Welcome back to the Deep Dive. Today, we're not
just looking at a historical event. We are walking
onto a crime scene. But this isn't your typical
crime scene. There's no yellow tape, no chalk
outlines. The weapon here was a calculator. The
accomplices were, well, everyone from the highest
paid bankers on Wall Street to maybe your neighbor
who bought that third investment condo. And the
victim was the entire global economy. It's good
to be here. And crime scene is, I think. exactly
the right way to frame this. It feels that way.
It does. We're essentially reopening a cold case
because the scale of the damage is still I mean,
it's still hard to really wrap your head around.
It really is. We're not talking about a bad quarter
for the stock market. We're talking about the
just the vaporization of wealth on a scale that's
hard to comprehend. Right. Let's just hit our
listeners with that headline number right away
just to set the stage. $13 trillion. That is
the number. U .S. household net worth plunged
by nearly $13 trillion from its peak in 2007.
That's a 20 percent drop. 20 percent. I mean,
just stop and think about that. Imagine one fifth
of everything American families owned, their
savings, their home equity, their retirement
funds, just gone. It vanished into thin air.
It's a number so large it almost becomes abstract.
You know, it sounds like something from astronomy,
not economics. But if you lived through 2008,
you felt it. Oh, absolutely. You saw the for
sale signs just multiplying like weeds on every
street. You saw office towers emptying out, people
carrying those cardboard boxes. You felt that
pit in your stomach when you went to the ATM
wondering if it was actually going to give you
cash. That fear was real. The system, and this
isn't an exaggeration. The system actually froze.
So today we're unpacking the subprime mortgage
crisis, but we're not going to do the dry textbook
version. We're going to treat this like a detective
story. We want to understand how the American
dream, the dream of homeownership, was weaponized.
Exactly. Our mission today is to strip away the
jargon. We've got a massive stack of sources
here. Reports from the Financial Crisis Inquiry
Commission, the FCIC. We've got Federal Reserve
data, archives of what people were actually saying
at the time. And looking at this stack, I have
to say it reads like a conspiracy thriller. It
does. But the twist is, it wasn't some secret
conspiracy happening in the shadows. This was
all happening in broad daylight. That's the crazy
part. And as the experts in these reports note,
this wasn't just one bad bank or one bad law.
It was a multinational financial crisis. It involved
regulators who were, frankly, asleep at the wheel,
credit rating agencies that were playing a completely
rigged game, and yes, consumers who were signing
papers they just didn't read or understand. So
let's find the smoking gun. Or... i guess the
thousands of smoking guns i want to start with
the aha moment i had digging through these sources
there was this specific financial innovation
and we're going to get into the weeds of it that
essentially turned dross into gold i mean financial
engineers found a way to take terrible incredibly
risky loans and dress them up as the safest investments
in the world And that innovation didn't just
happen in a vacuum. It was fueled by something
else, this giant pool of money that was just
circling the globe looking for a home. That is
the perfect place to start. To understand the
collapse, we have to understand the setup. We
have to go back to the years between 2000 and
2006. The bubble years. Exactly. So paint the
picture for us. The dot -com bubble had just
burst. 9 -11 had happened. The economy was on
the ropes. What did the Federal Reserve do? They
panicked. Arguably. The Fed, led by Alan Greenspan
at the time, was terrified of deflation. They
saw what happened in Japan, the lost decade,
and they wanted to stimulate growth at any cost.
So they pulled the biggest lever they have. They
did. They lowered interest rates. They did it
aggressively. The federal funds rate went from
6 .5 % in the year 2000 all the way down to just
1 % by 2003. 1%. I mean, it's basically free
money. If you're a bank, you can borrow from
the Fed for... Almost nothing. Exactly. And when
money is that cheap, you don't just sit on it.
You have to lend it out to make a profit. But
there was this other massive force at play here,
something Ben Bernanke, who was a Fed governor
then, called the global savings glut. The famous
giant pool of money. I love how the team at NPR
described this back in the day. It's such a great
visual. It's like there was this massive reservoir
of cash accumulating in the world and it just
had to go somewhere. It's the perfect visual.
Think about what was happening. You had these
fast growing economies in Asia, particularly
China, running huge trade surpluses with the
U .S. So they're selling us TVs and toys and
we're sending them billions of dollars. Billions
and billions. And you also had oil producing
nations, Saudi Arabia, Russia, making money hand
over fist as oil prices soared. So by the mid
2000s, there's about 70 trillion dollars with
a T. 70 trillion. 70 trillion dollars worldwide
in fixed income investments. All looking for
a home. But they couldn't just, you know, stuff
it under a mattress. They needed safety. Correct.
We're talking about sovereign wealth funds, central
banks. They aren't gambling on penny stocks.
They want safety and a steady return. And historically,
the safest place in the world for that money
was U .S. Treasury bonds. But there's the catch.
There's the catch. Remember, the Fed had cut
rates to 1%. So if you buy a U .S. Treasury bond,
you're making almost nothing. You're barely keeping
up with inflation, if that. Exactly. So this
$70 trillion was hunting for yield. It was desperate.
It was basically knocking on Wall Street's door
saying, I have billions. I need a safe place
to put it, but you have to get me a better return
than 1%. And Wall Street, being Wall Street,
said, don't worry, we can build a product for
you. And that product was mortgage debt. The
U .S. housing market was seen as the safest bet
on the planet. I mean, the phrase is safe as
houses, right? That phrase safe as houses is
doing a lot of heavy lifting here. Before we
get into the financial engineering, we have to
talk about the psychology on the ground. The
mania. Yes, the mania. Reading these sources,
the phrase irrational exuberance just keeps coming
up over and over again. There is this widespread,
unshakable belief that housing prices would never
fall. Not just that they would go up, but that
they literally could not go down on a national
scale. It seems insane in retrospect. It's the
definition of a bubble. It's a belief that defies
all historical reality. And look at the data
from the Fed archives. Between 1997 and 2006,
the median house price in the U .S. increased
by 124 percent. 124 percent. So let's just break
that down. That's doubling and then adding another
quarter on top of that in less than a decade.
If you bought a house for $200 ,000, suddenly
it's worth close to $450 ,000 and you didn't
do a thing. You just lived there. It felt like
magic. It felt like you were a financial genius
just for owning a home. And because prices kept
going up, homeownership rates hit an all -time
high of 69 .2 % in 2004. It became a no -lose
proposition in people's minds. Completely. Even
if you couldn't really afford the monthly payment,
the logic was, well, it doesn't matter. I'll
just sell it in a year for a $50 ,000 profit,
or I'll just refinance when the value goes up
and pull out cash. It stopped being about shelter
and started being about speculation. And the
data here is just wild. By 2006, the sources
say nearly 40 % of home purchases were not intended
as primary residences. That's a staggering statistic.
Let that sink in. 40%. These weren't families
looking for a backyard for the dog or a good
school district. These were investment properties,
vacation homes, or just pure naked speculation.
You had people flipping condos. Describe that
for a second because that flipping culture was
intense. You had entire TV shows dedicated to
it. Oh, absolutely. It was everywhere. You had
people in Miami or Las Vegas putting down a small
deposit on a condo that hadn't even been built
yet. They were buying the contract to purchase.
So they're buying a piece of paper. They're buying
a piece of paper. Then, six months later, before
the building is even finished, they sell that
paper contract to someone else for, say, $50
,000 more. The condo is still just a hole in
the ground, but the paper value has skyrocketed.
It turned housing into a form of day trading
for amateurs. But here's the problem. To keep
this machine going, to keep feeding that giant
pool of money with new mortgages... You need
more borrowers. Wall Street needed more raw material
for their bonds. And this is where they hit a
wall. In a normal functioning market, there are
only so many people with good credit scores,
a steady job, and a 20 % down payment. The prime
borrowers. Right. By 2003, 2004, the banks had
largely run out of those people. Everyone who
was qualified and wanted a house pretty much
already had one. But the giant pool of money
is still hungry. It wants more of these mortgage
bonds that pay 3, 4, 5%. So Wall Street had a
choice. They could either stop selling the product
that was making them fabulously wealthy or they
could lower the standards for the raw material.
And we know which one they chose. Which brings
us to our second section, the fuel. We have to
talk about subprime lending. This is the real
turning point. Subprime technically isn't a dirty
word. It just means borrowers with weakened credit
histories. Maybe they missed some payments in
the past. Maybe they have a high debt to income
ratio. Right. It was a niche market for a long
time. A very small niche. In 1994, it was about
5 % of all mortgage originations. Maybe $35 billion.
It was for people who were getting back on their
feet. By 2006. By 2006, subprime was 20 % of
the entire mortgage market. $600 billion in a
single year. That's an explosion. It's a more
than tenfold increase. But it's not just that
they were lending to people with lower credit
scores. It's how they were lending. The standards
didn't just get lower, they... They vanished.
They did. The sources described this alphabet
soup of loan types that sound like a comedy sketch
if the consequences weren't so tragic. This is
the race to the bottom. It really was. It started
with things like SEVA loans. That's stated income,
verified assets. Stated income. That's a very
polite way of saying liar's loan, isn't it? Pretty
much. The borrower just states on the application,
I make $100 ,000 a year. And the bank says, OK,
great. We believe you. Yeah. They might verify
your assets, like your bank account, but they
don't ask for pay stubs or tax returns. And then
it got worse. Then it got worse. You had neither
no income, verified assets, and then finally
the absolute bottom of the barrel, the NINO.
The NINJ loan, which stands for? No income, no
job, or assets. No income, no job, no assets.
You could literally walk into a mortgage broker's
office, have no job, no money in the bank, and
walk out with a loan for half a million dollars.
The running joke at the time, which was not a
joke, was if you can fog a mirror, you can get
a loan. I was reading this one anecdote in the
FCIC report about a strawberry picker in California.
This guy made maybe $14 ,000 a year. almost no
English, and somehow he was given a loan for
a house worth over $700 ,000. And you have to
ask, how does that even happen? Who signs off
on that? The mortgage broker signs off on it.
And this is the key to the whole puzzle. The
broker doesn't care if the loan is ever repaid.
The incentives were completely perverse. Explain
that. The broker gets paid a commission, an origination
fee, for selling the loan. The minute the papers
are signed, The broker gets their check, and
the loan is sold up the chain to a big bank.
The broker has zero risk. So their job isn't
to make a good loan. It's just to make a loan,
any loan. In fact, it was worse than that. Brokers
were often paid more, something called the yield
spread premium. If they could convince the borrower
to take a loan with a higher interest rate than
they actually qualified for. That's predatory.
That is literally incentivizing someone to rip
off their own customer. It was standard practice.
And the loan products themselves were traps.
We have to talk about the teaser rates. The exploding
loans. Yes. Imagine a 228 adjustable rate mortgage,
an ARM. For the first two years, the interest
rate is practically zero, 1%, 2%. Your monthly
payment looks incredibly affordable. So you think
you can handle it. You do. But at month 25, the
rate resets. It jumps to whatever the market
rate is plus a margin. It could explode to 9,
10, 11 percent. Your monthly payment could double
or triple overnight. And the sales pitch from
the broker was always, don't worry about the
reset. In two years, your house will be worth
so much more. You can just refinance into a better
loan. Exactly. The entire system was predicated
on one thing. House prices going up forever.
And then there were the option AROMs. These are
the ones that really blow my mind. You could
choose to pay less than the interest you owed
each month. It's called negative amortization.
And it's as bad as it sounds. Let's say the actual
interest on your loan is $2 ,000 a month. The
bank says, hey, you only have to pay $1 ,000
this month if you want. Sounds great. It sounds
great. But that missing $1 ,000 doesn't just
disappear. It gets added to your total loan balance.
So your debt is actually increasing every month,
even though you're making payments. You are literally
paying the bank. to go deeper into debt. It is
financial suicide. But again, if you believe
your house is gaining $5 ,000 in value every
month, you don't care. You think the house is
earning money faster than you're borrowing it.
The stats from the period are just. They're shocking.
In 2005, the median down payment for first -time
homebuyers was only 2%. 43 % put nothing down
at all. Zero down. You could buy a $400 ,000
asset with no skin in the game whatsoever. So,
okay, we have the strawberry picker with the
$700 ,000 loan. We have the mortgage broker who
got his commission and, I don't know, bought
a boat. But here's the mystery. Why would a big
bank, a sophisticated financial institution like
Bear Stearns or Lehman Brothers, buy that loan.
Why would they want a loan that is almost guaranteed
to default? Ah, and that brings us to the engine
of the crisis, the machine that made it all possible,
securitization. We need to unpack this carefully
because this is where a lot of people's eyes
glaze over. But it's actually not that complicated
if you use the right analogy. It's not. The concept
is simple. Historically, banking was what's called
originate to hold. Like in It's a Wonderful Life.
Exactly. George Bailey at the Bailey Building
and Loan. He lends you money to buy a house.
You pay the building and loan back every month
for 30 years. If you don't pay, the building
and loan loses money. They knew you. They checked
your credit. They had a stake in your success.
But that's not what was happening in the 2000s.
No, the model shifted completely to originate
to distribute. The local bank or mortgage broker
originates the loan, but they don't keep it.
They sell it almost immediately to an investment
bank on Wall Street. This creates what the economists
call a moral hazard. A massive moral hazard.
If the bank sells the risk the moment the loan
is made, do they care if the borrower defaults?
They have no reason to. The risk is gone. So
Wall Street buys thousands of these loans, good
ones, bad ones, NINJ loans, and throws them all
into a giant digital pot. They bundle them. And
these bundles are called mortgage -backed securities,
or MBS. Correct. Now imagine that pot of loans
is like... Well, a giant vat of chili. You've
got some prime cuts of steak in there, but you've
also got a lot of gristle and fat and things
you'd rather not identify. A wonderful image.
Go on. Wall Street takes that vat and they create
a product from it. And here's the magic trick.
They slice that product into different layers.
These are called tranches, which is just French
for slice. And this is the water bucket analogy
I saw in a few of the sources. I think this really
helps clarify it. It's the best one. Imagine
a waterfall. The water is the monthly mortgage
payments coming in from all the homeowners. And
that waterfall flows into several buckets stacked
vertically, one on top of the other. The top
bucket gets filled first. The top bucket gets
filled first. It's the senior tranche. As long
as money is flowing, this bucket gets full. So
if you buy a bond from this top bucket, you get
paid first. Even if a few homeowners stop paying,
if the water flow slows down a bit, that top
bucket is still going to get filled. And because
it's so safe, so likely to get filled. The credit
rating agencies, Moody's, Standard & Poor's,
Fitch, they come in and they stamp that top bucket
AAA. They say it is as safe as a U .S. Treasury
bond, the safest investment on Earth. OK, so
once the top bucket is full, the water overflows
into the next one down. Right. That's the mezzanine
tranche. It only gets paid after the senior guys
are paid in full. So it's riskier. To compensate
you for that risk, it pays a higher interest
rate. This might be rated, say, BBB. And the
very bottom bucket. That's the equity tranche,
or as the traders on Wall Street called it. the
toxic waste. This bucket takes the first losses.
If even a few homeowners default and the water
flow slows, this bucket stays empty. The investors
who bought this piece get nothing. They're wiped
out. OK, so on the surface, this seems logical.
Investors can choose their level of risk. The
problem, as the FCIC report points out, was that
Wall Street had too many subprime loans. They
had too much of this toxic waste and this mezzanine
stuff that nobody wanted to buy. That's right.
The giant pool of money, those global investors,
they only wanted the safe AAA stuff. There was
a glut of the risky slices. So what did they
do? So they did something that was either brilliant
or diabolical, depending on your point of view.
They took those unwanted, risky middle buckets.
the BBB -rated stuff from hundreds of different
mortgage bonds, and they pulled those together
into a new pile. So they're creating a new pile
made up of purely risky stuff. A pile of nothing
but B -level tranches. And they ran that pile
through the waterfall machine again. This new
structure is called a CDO, a collateralized debt
obligation. So it's a security made up of other
securities, a bond made out of other bonds. It's
a sausage made out of the gristle and leftover
bits from the first sausage. That is. Deeply
unappetizing. It's financial alchemy. Through
complex statistical modeling, they argued that
because these BDB tranches came from different
mortgage pools all over the country, some in
Florida, some in California, some in Arizona,
they were diversified. They wouldn't all default
at once. So they convinced the rating agencies.
They convinced the rating agencies that the top
portion of this new pile of risky debt was somehow.
magically safe again. I mean, it's unbelievable.
But 70 to 80 percent of this new CDO structure
was rated AAA. This is the draws into gold moment.
They took financial junk, repackaged it and slapped
a AAA sticker on it. And the rating agencies,
the so -called independent referees, they just
went along with this. Went along with it is putting
it very mildly. The sources highlight a massive,
glaring conflict of interest here. You have to
ask who pays for the rating? The bank. The investment
bank that's creating and selling the CDO. Correct.
The issuer pays. So imagine you're Goldman Sachs.
You go to Moody's and say, here's our new CDO.
We want a AAA rating. If Moody's says, wait a
minute, this stuff looks like garbage. We're
going to rate it junk. What does Goldman do?
They just walk down the street to S &P. Exactly.
They say, fine, we'll take our business to S
&P. Maybe they'll be more cooperative. It was
called rating shopping. And the agencies were
competing for this business. Viciously. Yeah.
They were making hundreds of millions of dollars
in fees from this business. There are internal
emails that came out in the NCIC report where
analysts are basically joking about it. I remember
one of these. One S &P analyst writes to another,
let's hope we are all wealthy and retired by
the time this house of cards blows up. Another
one famously said, we rate every deal. It could
be structured by cows and we would rate it. Structured
by cows. That tells you everything you need to
know about the integrity of the process. They
had every financial incentive to look the other
way. And their computer models, the things they
used to justify the ratings, were fundamentally
flawed. Because of that one big assumption. That
one core assumption. They assumed that because
housing prices had never fallen nationwide all
at once since the Great Depression, that they
never would. The famous diversification fallacy.
They thought a default in Miami had no connection
to a default in Las Vegas. Exactly. They didn't
realize that the financing was the national contagion.
When the credit spigot turned off, it would turn
off everywhere at once, and all their diversification
models would be worthless. So to recap, we have
the bad loans, the fuel. We have the CDO machine
turning them into fake safe assets, the engine.
But there's one more piece that turned this from
a messy housing correction into a global system
-threatening catastrophe. We need to talk about
the accelerant. This is where the story gets
really dark. This is the shadow banking system
and the concept of leverage. What is shadow banking?
When we think of a bank, we think of that building
on Main Street with a vault and tellers. That's
a depository bank, like Bank of America. It takes
deposits from you and me. It's heavily regulated.
It has to keep a certain amount of cash on hand.
But there was this whole other system operating
in parallel. The shadow barking system. These
are the big investment banks. Lehman Brothers,
Bear Stearns, Goldman Sachs, hedge funds, strange
entities called SIVs, structured investment vehicles.
What did they do? They acted like banks. They
borrowed short term and lent long term, but they
didn't take deposits. They weren't regulated
like banks. And they funded themselves by borrowing
massive amounts of money, often overnight. And
they used extreme leverage. Leverage is just
a fancy word for using borrowed money to invest.
If I have $1 of my own money and I borrow $9
to buy a $10 asset, I am leveraged 10 to 1. Which
is great if the value of that asset goes up.
It's fantastic. If that $10 asset goes up by
10 % to $11, I've doubled my money. I made a
dollar on my original dollar, 100 % return. But
if the asset drops by 10%. You've lost everything.
The asset is now worth $9. You still owe the
$9 you borrowed. Your original $1 is gone. Your
equity is completely wiped out. So now consider
this fact from the sources. By 2007, some of
these major investment banks had leverage ratios
as high as 40 to 1. 40 to 1. Let's just do the
math on that. That means for every $1 of their
own capital, they were playing with $40 of borrowed
money. So a tiny drop in the value of their assets
would wipe them out. A tiny drop. At 40 to 1
leverage, a drop in your asset value of just
2 .5 % makes you insolvent. Your capital is gone.
2 .5%, that's nothing. That's a bad Tuesday in
the stock market. And we're talking about housing
prices that had risen 124%. A 2 .5 % correction
was not just possible, it was inevitable. It
was. But they felt safe. Why? Because they were
holding all these AAA -rated CDOs. They believed
their own lie. They thought these assets were
bulletproof. And to make matters even crazier,
they were buying and selling insurance on these
assets. But this wasn't normal insurance. This
brings us to Credit Default Swap's CDS. A credit
default swap is, at its core, a side bet. It's
an insurance policy against a bond going bust.
If I buy a bond, I can also buy a CDS from you.
I pay you a small premium. If the bond defaults,
you, the seller of the swap, have to pay me the
full face value of the bond. But here's the twist
that turned it into a weapon of mass destruction.
You didn't have to own the underlying bond to
buy the insurance on it. That is the critical
world -changing difference. It's like buying
fire insurance on your neighbor's house. You
don't own the house. You have no insurable interest.
You are simply betting that it will burn down,
and you want to get paid if it does. And it's
not just you. Ten other people, a hundred other
people can all buy fire insurance on that same
house. Exactly. You could have a CDO worth $100
million, but you could have a billion dollars
in CDS bets riding on its performance. This is
how the potential losses in the system were magnified
infinitely. This led to the creation of synthetic
CDOs. Synthetic, meaning it's purely artificial.
It means there are no actual mortgages, no actual
homeowners involved anymore. It is just gamblers
making bets on the performance of other bets.
You had hedge funds who would actually help banks
design CDOs that they knew were full of garbage
loans. They could bet against them. Precisely.
So they could turn around and buy CDS from someone
else, betting that the very product they helped
create would fail. It's like helping someone
build a car with no brakes just so you can bet
on it crashing. The big short trade. That's the
one. But for every person making that bet, there
had to be someone on the other side. Someone
selling all that insurance. And that someone
was an AIG, American International Group, a big,
boring global insurance company. Or so everyone
thought. But there was a tiny division, a little
office in London called AIG. financial products.
And what were they doing? They were selling these
credit default swaps by the hundreds of billions.
They looked at the AAA ratings on these CDOs
and thought it was free money. They said, these
bonds will never default. We'll just collect
the insurance premiums forever and get rich.
They were picking up nickels in front of a steamroller.
A perfect analogy. And because CDS were unregulated.
They didn't have to put up any real collateral.
They didn't have the cash reserves to actually
pay out if all those houses they insured started
to burn down at the same time. They were insuring
the apocalypse, betting that the apocalypse would
never happen. And that's the final piece of the
puzzle. The stage is completely set. You have
a housing bubble. fueled by toxic subprime loans,
which are then securitized into fake safe bonds,
which are held by massively leveraged banks,
all of which is insured by a company that doesn't
actually have the money to pay the claims. It's
a house of cards soaked in gasoline. And in 2006,
the match was lit. It was. Which brings us to
Section 5, the collapse. From contained to catastrophe.
What was the first domino to fall? What was the
trigger? You know, it wasn't a sudden explosion
at first. It was more like a slow leak. Housing
prices officially peaked in the U .S. in mid
-2006. They went flat, and then they started
to tick down. And at the same time, the Federal
Reserve had started raising interest rates to
try and cool down the economy. That was the double
whammy. Those teaser rates on the 228 ARM started
to reset. Suddenly, homeowners saw their payments
jump by hundreds, sometimes thousands of dollars
a month. So they tried to do what the broker
told them to do. They tried to refinance. But
they couldn't. Because to refinance, you need
equity in your home. And for the first time in
years, the value of their house hadn't gone up.
It had gone down. Many of them were underwater.
They owed more on the mortgage than the house
was even worth. So the defaults started to spike.
And this is the beginning of the vicious cycle.
Defaults lead to foreclosures. The bank takes
the house and puts it on the market. That adds
more supply to the market, which pushes prices
down even further. Lower prices put more homeowners
underwater. which leads to more defaults. It
just feeds on itself. It does. And as those defaults
rose, the waterfalls in those CDOs started to
dry up. The toxic waste bucket emptied. Then
the mezzanine bucket. And then the moment no
one thought was possible, the AAA bucket of the
safe money wasn't getting paid. And that's when
the panic hit Wall Street. The timeline here
is important. The first signs of trouble were
the subprime lenders themselves going bankrupt
in early 2007. Companies you've never heard of,
like New Century Financial. At the time, the
Fed said the problems were contained to the subprime
sector. They did. That was the official line.
But the contagion spread to Wall Street in the
summer of 2007. July 2007 is when it got real.
Bear Stearns. Two of Bear Stearns' internal hedge
funds completely imploded. They were stuffed
to the gills with these subprime CDOs. That was
the... Proximate catalyst, as the SCIC called
it. It was the moment Wall Street looked around
and realized, oh, no, the toxic waste isn't just
out there. It's inside the house. It's on our
own balance sheets. And this leads to the modern
version of a run on the bank. But it wasn't people
lining up at teller windows like in the old movies.
No, this is a silent, invisible run happening
in the repo market. We need to explain the repo
market because this is the plumbing of the entire
financial system that nobody sees. Think of the
repo market as a giant overnight pawn shop for
banks. Investment banks like Bear Stearns and
Lehman Brothers need massive amounts of cash
every single day to operate and settle their
trades. So where do they get it? Every night
they take their assets, their bonds, their CDOs,
and they essentially pawn them to other lenders
like money market funds. for cash. They sign
an agreement to buy those assets back the next
morning for a slightly higher price. That's the
repurchase agreement or repo. So they are literally
living hand to mouth, night to night. Every single
night. They are rolling over billions, hundreds
of billions of dollars every night. The system
works fine as long as the lenders trust the collateral,
as long as they trust the bonds being pawned.
But in 2007, they stopped trusting the collateral.
They looked at the mortgage backed securities
being offered up by Bear Stearns and said, Wait
a minute. We don't know what this stuff is worth.
We don't want your bonds anymore. We want our
cash back. The pawn shop closed its doors. And
if you're an investment bank and you can't get
that overnight loan, you are dead by morning.
You can't open for business. That is what happened
to Bear Stearns in March of 2008. They ran out
of cash. The Federal Reserve had to step in and
orchestrate a fire sale to JPMorgan Chase just
to prevent a disorderly collapse that could take
down the whole system. And after that, everyone
took a breath. They thought, OK, the Fed saved
Bear. The worst is over. They thought they had
dodged a bullet. But it was just the warm -up
act for September 2008. The critical month. September
was the avalanche. First, early in the month,
Fannie Mae and Freddie Mac, the two government
-sponsored giants that owned or guarantee half
of all the mortgages in America, were effectively
bankrupt. The government had to take them over,
nationalize them. Then Lehman Brothers. Lehman
was in the same boat as Bear Stearns, but much
worse. They were leveraged to the hilt with toxic
commercial and residential real estate assets.
They were running out of cash. They desperately
needed a buyer or a bailout. But the government,
specifically Treasury Secretary Hank Paulson,
decided to draw a line in the sand. No more bailouts.
They were worried about moral hazard. They wanted
to teach Wall Street a lesson to show that there
are consequences for reckless behavior. So on
Monday, September 15th, 2008, Lehman Brothers
filed for bankruptcy. It was and still is the
largest bankruptcy filing in U .S. history. And
the result was immediate global chaos. The system
broke. The TED spread, which is a key measure
of trust between banks, it skyrocketed to levels
never seen before. It meant banks stopped lending
to each other, period. The circulatory system
of the global economy stopped flowing. And then
the panic, which had been confined to Wall Street,
hit the average person. It hit Main Street with
the money market funds. This, for me, is the
single scariest moment of the entire crisis.
The Reserve Primary Fund, a boring, safe money
market fund where regular people and companies
kept their cash. It held some Lehman debt. When
Lehman failed, the fund... Broke the buck. Meaning
a dollar that you invested was suddenly worth
only 97 cents. It doesn't sound like much, but
it was earth shattering. It was like discovering
the laws of physics no longer applied. It caused
a stampede. People and corporations started pulling
hundreds of billions of dollars out of every
money market fund. Because they were terrified.
If the government hadn't stepped in within 48
hours to guarantee those funds, the entire economy
would have ceased to function. Companies wouldn't
have been able to make payroll. ATMs might have
gone dark. It was that close. It was the brink
of a second Great Depression. And in the middle
of all this, AIG collapsed. All those credit
default swaps they had sold came due at once.
And they didn't have the money. Not even close.
And the government realized they couldn't let
AIG fail because AIG owed money to everyone.
If AIG went down, Goldman Sachs goes down, major
European banks go down, it would have been a
global financial Armageddon. So they bailed them
out, $85 billion initially. It eventually grew
to much, much more. It was a total, complete
systemic meltdown. So naturally, after a catastrophe
of this magnitude, we have to ask, who is to
blame? And the sources we've reviewed, they present
a few different, often competing narratives.
It's not just one villain twirling a mustache.
It's a cast of thousands. The first and maybe
the most prominent narrative is Wall Street greed
and deregulation. This one focuses on the idea
that the government took the referees off the
field and let the players run wild. Exactly.
Proponents of this view point to a few key decisions.
The repeal of the Glass -Steagall Act in 1999,
which tore down the wall between boring commercial
banking and risky investment banking. So banks
could gamble with their depositors' money. In
a way, yes. They also point to the Commodity
Futures Modernization Act of 2000, which specifically
stated that derivatives like credit default swaps
would not be regulated by anyone. They created
a completely dark, multi -trillion dollar corner
of the market where anything goes. And then there
was the SEC's decision in 2004 to allow the biggest
investment banks to dramatically increase their
leverage. The regulators were operating under
this free market philosophy that markets correct
themselves. Well, they didn't. And the FBI warned
of an epidemic of mortgage fraud as early as
2004, but very little was done. OK, so that's
narrative one. But then there's a competing narrative,
one you still hear a lot, which is that this
was actually the government's fault. It was government
housing policy. Right. This is the argument that
the government essentially forced banks to lend
to people who couldn't afford it. This argument
focuses on things like the Community Reinvestment
Act, or CRA, and the affordable housing goals
that were set for Fannie Mae and Freddie Mac.
The claim is that bureaucrats in Washington were
pushing for looser lending standards to promote
homeownership among lower -income communities.
But the sources, especially the official FCIC
report, seem to debunk this pretty hard. They
do. The FCIC conducted a very thorough investigation
and concluded that, one, the vast majority of
the toxic subprime loans were made by independent
mortgage companies that weren't even subject
to the CRA. So the law didn't apply to them anyway.
Right. And two, the loans that were made under
the CRA's framework actually performed better
on average than the private label subprime stuff
that Wall Street was churning out. And again,
there was a massive housing bubble in Spain and
in Ireland and the UK. They don't have a Community
Reinvestment Act. Exactly. It's hard to blame
a U .S. domestic policy for a global speculative
mania. Which brings us to the third narrative,
the one that maybe hits a little closer to home
for all of us, the consumer. We can't let ourselves
as a society off the hook completely. Households
took on massive, unsustainable amounts of debt.
People began to treat their homes like ATM machines.
Cash out refinancing. Yes. They would see their
home value go up, so they'd refinance a mortgage,
take tens of thousands of dollars of equity out
in cash, and use it to buy boats, cars, vacations,
flat screen TVs. The national savings rate plummeted.
And there was also the new phenomenon of strategic
default. This was a really interesting and controversial
new behavior. This wasn't people who couldn't
afford to pay their mortgage. This was people
who could afford to pay. But they looked at their
home's value, saw it was now worth less than
the loan, and they made a cold, rational business
decision to just walk away. They mailed the keys
back to the bank. Jingle mail. Jingle mail. And
left. It arguably broke the social contract of
debt, the idea that you pay back what you owe.
So it sounds like everyone is guilty. The regulators,
the bankers, the rating agencies, and the borrowers
all playing a role. The result was Section 7,
the aftermath. The human cost was just immense.
We talked about the $13 trillion in lost wealth.
But in terms of jobs, nearly 9 million jobs were
lost in the U .S. Unemployment doubled, hitting
10%. And the foreclosures. The number is just
gut -wrenching. Up to 9 million homes entered
foreclosure between 2009 and 2011. Think about
the trauma of that. 9 million families evicted,
lives upended, communities blighted with vacant
homes. And the recovery was the slowest since
World War II. We had this zombie economy for
years. The government's response was, of course,
the controversial TARP, the Troubled Asset Relief
Program. The $700 billion bailout for the banks.
And the Federal Reserve's response was to slash
interest rates to near zero, where they stayed
for years, and to start quantitative easing.
Basically printing money to buy bonds and inject
cash into the system. Now, here is a fact that
always surprises people when you bring it up.
The bailout money for the banks. We actually
got it all back, didn't we? We did. With interest.
As of 2021, the sources say the Treasury had
fully recovered all the TARP funds. plus about
$109 billion in profit for the taxpayer. Financially,
the government came out ahead. But socially?
Politically. Socially and politically, the cost
was incalculable. There was this profound sense
of injustice. We bailed out the banks, the architects
of the crisis, but we didn't really bail out
the homeowners who were losing everything. The
arsonists got a golden parachute while the victims
got burned. That perceived unfairness changed
American politics forever. You can draw a straight
line from that anger to the rise of the Tea Party
on the right, Occupy Wall Street on the left,
and the populist movements we still see today.
And we got the Dodd -Frank Act in 2010. The big
regulatory reform package. It was an attempt
to fix the too big to fail problem. It created
the Consumer Financial Protection Bureau to stop
predatory lending. It tried to bring some light
and regulation to the shadow banking system and
the derivatives market. But the big question
is, did it fix the root cause? That is the...
multi -trillion dollar question. And I think
that leads us perfectly to our final synthesis.
You look at this whole story and it really was
a perfect storm. You had low interest rates from
the Fed mixed with that giant global pool of
money hunting for yield combined with lax regulation
and a free market ideology fueled by financial
innovation that was brilliant but ultimately
toxic. And all of it built on a foundation of
bad incentives and a mass delusion about housing
prices. It was a disaster waiting to happen.
It was. And the recovery, what some call the
zombie economy, had these lingering effects,
especially on millennials. They entered the workforce
in the worst job market in generations, saddled
with student debt, and their rates of homeownership
still lagged behind previous generations. The
crisis left deep scars. So for our final provocative
closing thought, I want to reference something
the economist Robert Shiller said. He argued
that bubbles are primarily social phenomena.
That's the thought that keeps me up at night.
I think we've done a decent job of fixing the
plumbing, the specific mechanisms of the 2008
crisis. Banks have more capital. The rules around
mortgages are stricter. But have we fixed the
psychology? Have we fixed the human brain? Exactly.
Have we cured ourselves of the fear of missing
out? of greed, of the belief that this time is
different. The mechanisms change, but the behavior
stays the same. It does. Maybe the next time
is not subprime mortgages. Maybe it's crypto
or private credit or some new tech stock bubble.
But as long as you have a period of cheap money
and a compelling story that says prices can only
go up. you will get a bubble. And you will have
financial engineers in the background figuring
out new ways to turn dross into gold. Always.
A very sobering thought to end on. We have barely
scratched the surface of the thousands of pages
in these reports. If you want to see the emails,
the charts, the actual crime scene photos from
the financial collapse, check out the links in
our show notes. It's a deep rabbit hole, but
it's worth going down. Thanks for taking the
deep dive with us. We'll see you next time.