For the last year, many people have been staring at their retirement statements in shocked disbelief and wondering how we got into this mess. The answer is a complex and sordid tale of financial innovation, deregulation, greed, and excessive use of acronyms. Rampant deregulation and cheap credit created the unusual situation in which selling a $500,000 house to someone who couldn't afford it could be hugely profitable. Who could have known that would end badly?
The scam worked like this, a mortgage broker would sell a $500,000 house. If they couldn't find anyone who could afford a $500,000 two-bedroom house, they could use an adjustable rate, interest-only liar loan to sell it to someone who couldn't afford it. Under normal circumstances, they would be fired for this, but this was a brave new economy where financial innovation could turn lead into gold. The mortgage broker, didn't care if the loan was repaid because they could sell this crappy loan to investment banks who would bundle it with all sorts of other crappy loans and create a collateralized debt obligation (CDO). Ratings agencies, that were paid by the banks, would then sprinkle the loans with the pixie dust of complex mathematical equations and declare it "no longer crappy", otherwise known as AAA. They could then sell this AAA-rated CDO to investors and pension funds around the world and earn large commissions. In short, create an illusory asset, repackage and sell it multiple times skimming a little off the top each time and hope you aren't holding it when reality hits.
When it got harder to find enough people to take on more crappy loans, banks and insurance companies like AIG started using credit default swap (CDS) to gamble on other peoples's crappy loans and just about anything else. The totally unregulated CDO and CDS markets soon became larger than the entire global economy and the huge investment banks took on massive amounts of debt to maximize their profit. The fact that companies didn't have enough capital to cover their bets was not a problem because...well just because. So to recap, banks and AIG gambled on AAA-rated CDO's with CDS's and the SEC was MIA, WTF.
As long as house prices kept going up, everyone was happy. Mortgage brokers got a big commission, homeowners could flip their house for a profit, consumers were feeling rich from rising home prices and took out home equity loans to buy flat-screen TV’s made in China, the Chinese got manufacturing jobs, businesses sold TV’s, ratings agencies made lots of money, Wall Street was rolling in cash, bank executives became filthy rich, George Bush got to claim we had a strong economy with record home ownership, and politicians from both parties received large campaign contributions from the aforementioned filthy rich bank executives.
But this amounted to the largest gamble in world history, heads-Wall Street makes billions, tails-the economy collapses. In retrospect, letting a handful of narcissistic multi-millionaires turn the global economy into a huge casino for their own enrichment may have been a tad unwise, but at the time everyone was having too much fun spending borrowed money and watching their flat-screen TVs to care.
The house of cards came crashing down when people suddenly realized that they really couldn’t afford a flat-screen TV, much less a $500,000 two-bedroom house. House prices collapsed leaving many homeowners deeply in debt. As consumers watched their retirement savings vanish, they wisely stopped spending. Unfortunately, this made the economy even worse by further lowering house prices and flat-screen TV sales. AAA-rated CDOs morphed into the now famous "toxic assets" and CDS gambles had to be paid off causing economic chaos around the globe.
So where does that leave us? The 'too big to fail' financial firms lost trillions and are still too big to fail (thanks to taxpayer bailouts), Wall Street executives still receive huge "retention" bonuses (now paid from taxpayer bailouts), politicians still receive large contributions from Wall Street (now paid by taxpayers), many small businesses went bankrupt (and didn’t get bailed out), the middle-class lost their home, job and/or retirement savings (and didn’t get bailed out), and our kids will have to pay for it all.
I imagine there is a moral there somewhere.