Crash of 2008, Help Understanding

>>1842183
So essentially mortgages are (were) considered very safe credits to hold, because people prioritized paying their mortgage over all other daily expenses so defaults on mortgages that were decently rated were very rare. In the 70s, a guy introduced the Mortgage Backed Security, which is a tradeable financial instrument that uses the debit safety of mortgages to essentially give it value/stability. This is the historical background scene in the big short where a guy invents these and sells them to a pension fund.

Over time these MBSs were collected into Collateralized Debt Organizations, which were essentially massive bundles of these securities that would be traded at once. These CDOs had ratings given to them that were an aggregate of the ratings given to each mortgage, for example, AAA or A or BBB, etc. Typically a highly rated CDO would contain a fair number of low rated securities, but the default rate on AAA and AA bonds was so incredibly low that they were considered safe. Now a lot of firms traded, owned, and particularly had large leveraged (borrowing money to invest) positions on these CDOs.

The major market error was essentially vastly underestimating the default risk on these instruments. This is a vital area, in fact, entire departments are devoted to Risk Management and some of the most prestigious quantitative jobs on wall street are in RM. In the big short, several market actors realize this discrepancy in risk valuation and exploit it in different ways: the two young guys, with small amounts of capital, purchase Credit Default Swaps, which are instruments allowing them to essentially take out insurance on these mortgages (that they don't own). Typically a credit default swap would be used by a firm that owns large numbers of CDOs to hedge itself: they pay a little bit of money in exchange for the assurance that if the mortgages default, they will be paid back from whoever they purchased the swap from.

>>1842201
(2/2) The novelty in the young guys' approach was basically to buy these swaps as an investment vehicle. Usually they are low volatility, not a speculative position, and purchased like I said by extremely high net worth firms as a way to just eliminate risk. But they realized that the swaps were the best way to profit off of the impending crash, since they could not do what Michael Burry did, which is have other institutional investors write instruments for them allowing them to short the market (they didn't have an ISDA, which is necessary to do this). What Burry did was go to a bunch of banks and get them to write him contracts saying every month he would pay them the difference between his position and the value of the CDOs he was shorting, but then he would be paid off massively if they dropped below his entry point. (This is a simplification but it's what the result of the instruments was so it doesn't matter).

Now another plot point is the Steve Carrel character, who uses his firm (fuckload more money than the young guys but less money than Burry by a fuckload) to buy instruments shorting the entire CDO array of mortgages: BBB, BB, other low quality bonds, but insightfully (this is the scene where Ryan Gosling plays with Jenga blocks) realize that the failure of these bonds will have a cascading effect and also cause the A,AA,AAA bonds to default. And they can get a really really good deal on shorting these bonds, because everyone thinks they are virtually risk-free. In buying these instruments, they don't realize who exactly is selling to them. At the end of the movie, it is revealed that Merrill Lynch has also realized the risk valuation discrepancy from the beginning, but only has short positions on the LOW rated bonds, and in fact financed these short positions with the sale of long positions, to Steve Carrel's character and others, on the HIGH rated bonds. Hence when the low rated bonds fail, the high rated bonds also fail, and Merrill Lynch

>>1842183
suffers enormous losses. The leveraged positions on these CDOs also wipe out other firms (that failed to reorganize their positions fast enough) such as Lehman Brothers. Goldman Sachs is an example of a firm that, while suffering enormous losses, managed to essentially reorganize fast enough to mitigate complete bankruptcy. This is even included in the movie: the indian goldman sachs rep contacts Burry to negotiate payment on his instruments, and Burry accuses him of only deciding to call and realize those positions when Goldman Sachs has achieved a 'net short position' i.e. has reorganized their investments enough that they now profit from the decline of the housing market as opposed to their, and everyone else's, original long positions.

>>1842183
In a sense like you said the issue is giving loans to people who won't pay, but from a market perspective, the issue is really the error in risk assessment of those mortgages. When the characters fly to Florida and meet with low level real estate brokers--those guys ideally have it in their best interest to only give mortgages to people who will pay them back, but since the major banks have failed to assess the risk of these mortgage defaults and have begun buying the mortgages off of those guys to package into CDOs, the guys (and everyone else) has no incentive to actually screen who they sell to, because the bank that buys the mortgages from them assumes the risk.


So it's basically 1)people are unreliable debitors 2)banks continue to assess mortgages as nearly risk free --> mortgage brokers, instead of not selling houses to unreliable people, are enabled to sell to literally anyone because the major banks will buy the mortgages from the brokers and assume the risk --> lots of unreliable people have mortgages sold to them at an exponentially accelerating rate --> those people default and the major banks have no risk management surrounding these instruments because they never expected those defaults to become significant

>>1842222

Nice quads. But here is my question. Why did so many people seemingly simultaneously default?

>>1842227
The 4chan gods bless me for taking 20 min to type that all up.

That's a good question. It isn't so much that they all defaulted at once, it's that the rate of leveraging, mortgage issue to unreliable people, and rating discrepancy got so high that it couldn't be ignored.

What it really is is the way a bubble works. The "bubble" was the delusion that these securities were risk-free and that we could give mortgages to anyone. A bubble is called a bubble for a reason--it grows and grows over time, but when it pops, it fucking evaporates. As soon as one rating agency starts rating things the way they should be, and one major firm starts closing positions, the market catches on. And suddenly everyone is panic selling, all the rating agencies have to stop with their charade that everything is fine, so you have a sudden drop from high ratings to low ratings, risk valuations spike, firms' models indicate a rebalancing of positions towards neutral or short on housing, and everyone does this at once in a race to get ahead of the pop.

In short: Once the first jenga block is removed, the rest inevitably and very catastrophically will collapse. Bubble bursts are self perpetuating panic slides and once they start there is no stopping them.

>>1842201
Thanks for the detailed response it was really informative.
It seems strange that they kept giving out the loans after the subprime loss rate started to go up and everyone just brushed it off.
I guess in hindsight it makes sense but I always thought after the great depression people where really wary of being so sure in a system that essentially became a gamble, strange events that I hope don't repeat themselves

>>1842232
market bubbles are an inevitability. Tulip Mania to internet to housing it's all the same pattern. It will inevitably repeat itself again, because it is more a manifestation of human nature than any financial concept

>>1842242

Do you feel like we have any sort of bubble akin to 2008 currently?

>>1842243
No, but there could be the beginnings of one. People will say it's "student loans" like they are smart but it really isn't student loans. A bubble isn't just loans, it needs instruments to be premised on them and enormous buy pressure, which there simply isn't.

You might, depending on adoption, see a cryptocurrency bubble within the next decade or two. Currently cryptocurrency is undervalued in my opinion, but once institutional investors start latching on and developers are making tech around crypto the way they made websites, etc we could see "another dot com bubble" so to speak

>>1842268

Alright cool. I am gonna head offline for now. I'm not OP but thank you for taking the time to type and explain all this out. I know the thread hasn't gotten a lot of traction, but I really appreciate that you typed up all your info regardless. Have a good night/day!

>>1842183
Basically this:
Fannie mae/ Freddie mac had no real guidelines, they bought all the loans and sold them on the secondary market. These loans could be 800 fico 20% down 300k a year to people on foodstamps buying their 5th property.

Investment banks had math wizards tranche them all together to make them look decent risk wise and had ratings agency give it the A+ or else Ibanks would go else where to get their ratings. Money was flowing so they said fukit.

Trillions of dollars worth of loans were now in Ibanks books, most of which looked clean as fuark.

Meanwhile appraisers were still getting paid off to jack up appraisal values by loan officers. This created crazy high artificial home prices, all which were dogshit int only arms they were bound to go up and people couldnt afford the shock. People kept refinancing to take money out as their home was worth more and more daily from fake appraised values.

Then came the leveraged cdos. pretty much people saying fuk that, that mortgage back security will fail, ill bet 10:1 that it will and get [paid on it if it does. Then came the artificial cdos where you could bet on multiple cdos failing.

Everything was leveraged to hell, people were maxing their cash outs, appraisers getting paid off to keep it going. When some of the arms started to fail, as maturation date came due, everything started failing, banks couldnt pay off the cdos which were leveraged by even more cdos. Was like sparking a match on a gasoline trail that lead to a warehouse of dynamite.

Its habbening all over again btw, im in the mortgage industry. Appraisers dont even get paid off anymore and they are still appraising things retardely because of comps. Lenders pushing int only arms and arms again. Seen some manual underwrites on FHA below500. Top keks will be had.

>>1842227
They didn't. The CDO's were being used as collateral in the overnight lending market. I.e. What banks and such use for liquidity https://en.m.wikipedia.org/wiki/Overnight_rate
Keep in mind by this point small city governments in Norway were buying CDO's and the like for investments. All it took for the cascade was the overnight market to dry up, and because the investment banks and such were leveraged 33to1 or more at that point, at that level, even a 3% swing in asset prices would make them insolvent.
There is a lot more to it than that.
Also keep in mind the risk profile of housing is considered local, so a housing dip in el paseo (due to say job loss) doesn't reflect housing in new jersey. I forget the technical term. But what they did was mix housing in from different places in the same CDO's on propose to reduce risk, but it actually increased risk by tying them together and creating the single market that they wanted to avoid.
Another way their risk models were wrong were they took the biggest housing dip they could find, I think it was 40% in a part of Texas, and used that as thier floor in a technical risk model VaR that proports to distribute all thier ricks collective into a bell curve, that disregards unknown and unknowable events. But risk isn't a bell curve, it only appears to be when you have a limited sample, and no sample of the future.

>>1842313
>Fannie mae/ Freddie mac
Blaming the fannienmac meme has been thoroughly discredited.

>>1842313

meant to put Credit default swaps in there somewhere but a bit drunk.

>>1842322
they are like 5-10 % to blame. They didnt give a fuk bought and sold everything.

Not going to lie, it was the loan officers who gave out shitty loans for massive commisions, people who were to stupid to understand it was a bubble and took out 800k cash out int only arms in ghetto neighborhoods, appraisers who got paid off to keep pushing prices higher, credit agencies for wanting to stay in business so they wrote A+ on everything.

It was a giant shit show to find out who could make the most while the party was going from the homeowner to the banks.

And guess what? NINJA are coming back soon, low ficos dont really matter anymore, stated income, 100% gift funds, int only arms. you name it is probably out there. Hell Ive seen people in BK with past forclosures before the bk do cash out refis on int only arm.

People dont think it be like it is but it do.

>>1842334
Fair. I take back what I said. What I really meant was they weren't the beginning and end, or the only

>>1842268
Great job explaining and thank you for taking the time to type that out anon.
Wasn't there also what was basically insurance on CDOs. Didn't it basically allow for banks to up their leverage even more as it was "hedged" however the insurance didn't need to hold barley any collateral due to lack of laws. The agencies also got to collect billions in fees to insure something that was believed to be extremely low risk. If I remember correctly this insurance was one of the ways banks kept their books so clean until the agencies failed leaving the banks still holding their own mess

>>1842183
https://www.youtube.com/watch?v=D9ub25WjEK0

Inside Job is a great documentary about the 2008 financial collapse.

This version is shitty because of copyrights, I would suggest downloading a torrent.