The Big Short – Understanding the Financial Crisis

Last night I watched The Big Short, the five-time Oscar nominated movie. It made me realise how little I really knew about what happened leading up to the financial crisis of 2008/09, despite having studied economics for nearly 3 years.

During this post I will discuss the causes of this disastrous period.

I already understood the main cause of the financial crisis being the housing market bubble which was caused by subprime mortgages given out with very few (if any) credit checks, resulting an unstable market with people unable to pay their debts. Eventually, the bubble burst and banks collapsed. But lets go deeper….

Bankers played their part, believing there was no risk the housing market would collapse. During the Great Moderation people began to believe the world economy had outgrown the days of the business cycle, when simply, it had forgotten about the serious risks of a crash occurring. 

Additionally, central bankers must hold part of the blame as it is argued they became too complacent with what appeared to be strong economic conditions leading up to the crisis, holding interest rates too low encouraging subprime lending, making no attempt to stop the housing bubble.

In the years leading up to the crisis irresponsible mortgage lending in the US meant loans were given to subprime borrowers with a poor credit history. These loans were pooled together with the belief that their risks were uncorrelated – in hindsight this seems foolish as housing markets simultaneously crashed across the US. These pools were used to back securities known as collateralised debt obligations (CDO’s) which are structured financial products that grouped these mortgages into discrete tranches that could be sold to investors. These securities appeared to be safe products with high returns attracting large amounts of investment. The AAA ratings were misleading but were given by agencies which feared losing out to competition if they did not give such ratings. The mortgages within these CDO’s were not secure but ‘ticking time bombs’ as more and more people defaulted on their debts. 

The high yield and apparent low risk CDO’s spread throughout International Financial Markets.

From 2006, the housing bubble was increasing inflation, so the US Central bank was raising interest rates in an effort to control it. The cost of borrowing rose, and more subprime borrowers were finding it increasingly difficult to repay their mortgages, defaulting on their loans. Lenders were now reselling these houses into a declining housing market. Correspondingly, there was a reduced demand for CDOs, as the number of defaults on mortgage payments increased.

Now traders looked to repackage the risk and selfishly create further business rather than writing off their CDO’s, not just delaying but accentuating the eventual crash. The traders split the worst elements out of their CDOs to create new CDOs. When an increasing proportions of these CDOs failed to sell, they would be sliced up and the worst bits sold into new CDOs that the traders created. In the height of the housing boom around 2005 the riskiest securities accounted for around 5% of a CDO. By 2007 they accounted for as much as 40% – effectively there was a multiplier of risk in these securities being sold.

The realisation of these banks holding worthless assets came from around Q2 2007 onwards. Many CDOs were finally downgraded by ratings agencies.

When the financial crisis peaked in 2008 crippling the banking sector, banks found themselves holding billions in worthless assets. With many banks suffering huge losses, no bank wanted to lend to another potentially failing bank, so interbank lending effectively stopped. This was the start of the economic turmoil that followed.

Even though the whole the financial crisis is shocking, ruining countless livelihoods, what is more chilling is that despite 50 CDO managers being investigated, only 1 was prosecuted.

While this is not the full story, this summarises the main cause of the largest financial crisis since the Great Depression 1929.

I recommend watching The Big Short for an insight into the financial crisis and how some people predicted it would happen and actually benefitted from it.