Financial Crisis 2000s: Reason Number 2

In a previous post on this blog, the first reason for the financial crisis was discussed: housing prices don't always go up, and lots of people bought houses assuming that they could re-finance their mortgages when housing prices go up.

Financial service companies, such as Goldman-Sachs, created a new way to earn money from mortgages. They figured out how to buy a bunch of mortgages and then create new bonds whose interest and principal were paid by those mortgages. Each new bond was rated based on the likelihood that interest and principal payments could be collected from the mortgages backing that bond. If only a few mortgages backing a particular bond defaulted, then the bond could still be paid (though the financial service company that created the bond might make less money). Once each new bond was created, it could then be divided into shares and sold to multiple buyers, just like other types of bonds.

One of the complexities of these new bonds which were backed by a group of mortgages was that each mortgage could be allocated to several of the new bonds, spreading the risk of any particular mortgage defaulting among several bonds. However, this splitting makes it very hard to figure out who owns each mortgage. Suppose, for example, 10% of a mortgage allocated to each of 10 new bonds and those 10 new bonds each are split into 100 shares. If that mortgage defaults, there are 1000 owners of the 10 new bonds which are affected by that one default.

The company that created each new bond could buy an insurance policy for each bond in case to many of its underlying mortgages defaulted. The insurance policy could then be used to pay the holder of the new bond. Thus, for the company creating the new bond, there was no apparent risk.

Finally, a company (not necessarily one that created the bond) could make even more money by entering into a contract that behaves like insurance on a bond even if they didn't hold the bond. This kind of contract pays the company if the bond defaults. One insurance company, AIG, sold a lot of these contracts to a variety of companies.

When lots of mortgages started to fail, this started a whole series of failures in the bonds created by the financial services companies. When those bonds started to fail, anyone who had contracts that either insured against such failure or just paid off when the bonds failed, tried to collect on their contracts. So many of these contracts were with AIG that when all of the underlying bonds defaulted, AIG didn't have enough money to pay for these contracts. As a result, AIG went bankrupt. When AIG went bankrupt, nobody could figure out how much money these contracts were actually worth. Because of that uncertainty, banks stopped lending money to each other. And, when banks stopped lending to each other, they also stopped lending to the businesses that depend on them, freezing business activity and resulting in a financial crisis in 2008 that affected the entire economy.