The Financial Crisis 2008 -- Part Three

Who are the members of this shadow banking system and exactly where did this whole thing go wrong?

The members of this shadow banking system are mostly the investments banks, hedge funds, and other financial entities that did not fall into the traditional definition of a commercial bank. Bear Stearns, Lehman Brothers, Goldman Sachs, Morgan Stanley, Merrill Lynch are the 5 traditional investment banks in the US, and they were businesses outside of traditional regulation.

And where did this whole thing go wrong? Everywhere. This financial crisis was a societal failure. Everyone was at fault here from the common citizen to the CEO to the government at their highest levels. When I hear some pundits or analysts or talk show hosts say that the government or CEO's should be blamed, I find it really shallow. It's not that government regulatory bodies and big business were faultless, but they alone did not create the mess we find ourselves in. Everyone was at fault. The way society evolved made this an accident waiting to happen. It's like a village living at the foot of a volcano.

In my opinion, the best way to understand how this crisis evolved into something so damaging is to concentrate on the role of the traditional commercial banks. Let me be clear that I do not think they are the ones with the biggest share of the blame, but rather understanding it from their perspective is the easiest way to grasp the entire situation.

I explained in the previous part how traditional banks make money and how they are limited by regulations. But these commercial banks were able to make their way around the regulations by selling their loans to the shadow banking system! Therefore, these loans they passed on are now flying under the regulatory scope and the banks are then free to make new loans.

Let's give a hypothetical situation using real banks' names to make it explicit. Let's say the commercial bank is Wachovia. The investment bank is Lehman. And the customer is Mr. Roberts. Mr. Roberts goes to Wachovia to take out a mortgage loan to buy a home. Wachovia then gives Mr. Roberts 100,000 USD for the loan. And then, Wachovia sells this loan to Lehman Brothers. Lehman gives 100,000 USD to Wachovia. And all the interest and principal repayments that Mr. Roberts makes on the loan is passed onto Lehman. And presto, Wachovia has 100,000 USD back free to make more loans as if Mr. Roberts's loan never took place. Lehman is now the one holding all the risk of the mortgage but is also the one who is repaid from the loan.

Why would each party want to do this? For Wachovia, they just make the processing and administrative fees, without taking on the risk of the loan. So they make more money without going over their regulatory limits.

As for why Lehman would want to buy these small loans, it's a bit more complicated. There was this hot craze of in the financial world called financial engineering. Think of these new financial engineers as the witch doctors of finance. These small home mortgage loans from the public were the basic ingredients of the toxic alphabet soup they were concocting. They come with many names, CDOs, MBS, ABS, with SIVs buying them up. They 'bundled' these small loans and made them into large loans that they in turn sold as bonds to pension funds, endowments, hedge funds, etc. This toxic soup was a big hit and proved to be addictive to they buyers because they appeared to be safe. The ratings agencies (S&P, Moody's, Fitch) even rated these bonds as investment grade.

So now we had these voodoo instruments posing as bonds that purportedly offered higher payouts than your normal bonds. Everyone loved them, so the investment banks kept making more of them. And to make more of them, they demanded more of the small loans from the commercial banks as their ingredients. The small banks were more than happy to oblige. They encouraged Mr. Roberts to take on more loans. Since they were so free to make more loans because the investment banks were taking off their balance sheets for them, they tried to seduce Mr. Roberts with a lot of sweeteners to the loans like Adjustable Rates.

To make things worse, there was a speculative bubble forming in the housing market that artificially inflated prices of houses. This only made banks more eager to give out loans based on the rising values of the houses.

To bring it home, Mr. Roberts, so seduced by the attractive rates and 'easy terms' of the loans the banks were offering, takes on bigger loans to buy a bigger and better house. The bank assures him that as long as the house price keeps going up, then he can "refinance" his loan based on the house's appreciating value.

And there you have it, the elements and set up for a disaster. First, we have ordinary people and households, so seduced by the banks that they start living beyond their means on CREDIT. Whatever happened to savings and the value of keeping something away for a rainy day? According to CNN, the average American household has about $9,200 in debt and according to MSNBC, 43% of Americans spend more than what they earn.

Second, you have the commercial banks being able to pass their loans and risks to the shadow banking system, making them free to make more loans and just making money from the administration of these loans. They don't bear the risk of the loans on their balance sheets so they have an incentive to just keep on pushing people to make loans.

Third, you have the investment banks with their witch doctors buying these small loans from the commercial banks, bundling them together and magically coming up with investment-grade bonds. Even the ratings companies were in on it and rated these bonds highly.

All the while, government willfully turned a blind eye because lobbyists wined and dined officials to turn the other way because anyway, everyone was making money.

Then, it all went wrong... (to be continued...