Derivatives, Freddie Mac, Toxic Mortgages...
Terms you've heard bantered about I'm sure. Yet no one I've heard has ever explained in clear language what happened. I mean apart from political ad hominem attacks. Here's the short version...
1. Banks made home loans to people they knew could not pay them back.
2. The banks that made these loans knew they had to get rid of them or they would lose money when they defaulted.
3. The banks bundled these bad loans together with other loans to conceal the bad loans when they tried to sell them.
4. After selling the loans, the banks then essentially placed bets that these loans would default.
5. The loans defaulted sparking a chain reaction that resulted in near destruction of the financial system, a prolonged recession that c and making a small amount of people a tremendous amount of money.
Driven by competition and low interest rates banks began making home loans to people they knew probably couldn't pay the loans back. In a well functioning financial system this would just mean that the banks that make these kinds of loans would go out of business once the loans default. However due to the complexities of our financial system that did not happen. In fact many of the banks that made these bad loans ended up profiting from them. Here's how:
The banks knew if they held onto these loans eventually they would default and they would lose money, so they had to sell the loans. There are two large government backed companies called Fannie Mae and Freddie Mac that buy these kinds of loans but the banks knew that Fannie and Freddie would not want to buy them if they knew they were filled with these bad loans, a.k.a. "toxic mortgages". In order to be able to sell these loans they sold them in bulk by combining them with lots of other loans that were generally safe (think of a rubber band manufacturer mixing in broken rubber bands into bags filled with thousands of rubber bands, you'd never notice the broken ones).
Fannie Mae and Freddie Mac (along with every other financial agency) relies on ratings to determine it's financial value. "Rating Agencies" like Moody's or S&P are companies that give a rating to mortgages (among other things) and they continuously gave these toxic mortgagees the highest possible rating of AAA. They did this partially because the bundled mortgages were simply too big to fully understand, partly because they assumed the well established banks that were selling them would not sell bad mortgages and partly because they benefited directly from rating them highly. The rating agencies are financed by these very banks they rate and so it was in their interest to rate them highly.
If this had been all that happened it would have been outrageous and criminal. However it did not stop here. The banks that gave these toxic mortages and then sold them to Fannie and Freddie then proceeded to go a step further and bet that they would default. In the same way that you can buy car insurance in case something bad happens to your car these people bought a form of insurance in case something bad happened to these mortgages. The difference of course is they knowingly built the car with broken parts and sold it to someone knowing it would break down. In 2008 the cars began to break down. To make matters worse most of the banks all bought their insurance policies or "derivatives" from the same company, AIG.
Once it became clear these mortages were toxic it started a chain reaction. Fannie Mae and Freddie Mac were hemmoraging money, AIG owed hundreds of billions in "derivatives", banks could no longer sell their mortages or get insurance making them unwilling to lend money. This in turn threatened to completely shut down the banking system. Several large banks collapsed as a result and the remaining banks bought them making themselves even larger.
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