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2008 Financial Crisis:
How did the world collapse?

10 - 12 Minutes

Leela Tarang Krishna

Consumer Insights

Let me tell you a story.

It is a story about how a formless paper provided millions of dollars to those who owned it, how it led to a loss of 2 Trillion Dollars in the global economy, how more than 8.7 Million people lost their jobs, and how more than 1.8 Million companies went bankrupt.

At its best, it's the story of how a mortgage loan can be used to build a nation. At its worst, it is how a mortgage loan can lead to the collapse of 198 Countries.

It is the story of the 2008 Global Financial Crisis, and it begins with one brilliant man named Lewis Raneri figuring out a way to make millions from a mortgage loan.

The Brilliance of a Creator:

The Brilliance of a Creator

Giving loans is the primary purpose of a bank. Its income is the interest paid upon the loans provided. To ensure the repayment of the loan, including the interest thereon, the bank undertakes an extensive background check of the person's credibility. Nevertheless, there is always a degree of risk associated with giving bank loans, as the borrower may default on the payment of a loan.

What if that risk is transferred to someone else? What if the one taking the risk becomes the collector of the principal and the interest instead of the Bank? What if the Bank, by letting that person be the collector, gets all the principal it has given and the interest it would receive over the next few years from the person willing to assume the risk? What if this happens on every loan that the Bank has given?

Essentially, a person would get to fulfil their dream of a house. Because it is a bit risky, the bank sells that mortgage loan to someone who wants to assume that risk for a price calculated by adding the principal loan and the interest expected to be received. It would gain the money it has lent in exchange for the rights to collect the loan’s principal and interest.

I know what you are wondering - it is the Bank's duty to collect the money and to get the principal and the interest; ergo, it is the Bank's risk. Why would anyone assume the risk of nonpayment of a loan on behalf of the bank? Why would anyone step in as a collector instead of the Bank? What is their incentive?

You are right. No one would.

Unless they think that if they purchase all or some of the mortgages that the Bank has, they can get significant money periodically (as collectors) over the next few years, which can be used for investment purposes.

Suddenly, substituting oneself as the principal and interest collector becomes a very lucrative option. Suddenly, planning for the future becomes extremely easy, for assured cash flow exists. Suddenly, the Banks and investors are rich - they can invest in many products and improve many services, and people can fulfil their lifelong dream of owning a home.

A seemingly perfect world is created if the risk for the Bank is transferred, and Lewis Ranieri, a former New York bond trader, was the first to develop an instrument that embodies this idea.

He created a Mortgage-backed security (MBS).

The face of development:

The face of development

A mortgage-backed security (MBS) is a security (like a bond) comprising thousands and thousands of mortgages bundled together onto one piece of paper. Whoever owns the security gets all the principal & interest from all the mortgages inside the security, and in the 2000s, after Lewis Ranieri created MBS, people started purchasing them by paying an exorbitant amount (calculated by adding the principal and the interest that the Bank is owed to receive).

The reasons for the success of MBS were twofold. One - who wouldn't want a guaranteed income source that will not stop providing money periodically? Two - MBS is better than taking debt (which involves incurring liability, thereby increasing the costs associated with the risk of failure) or selling company shares to strangers (which inevitably involves diluting control to unknown owners). Every player that purchased mortgage-backed securities, consisting of tranches of mortgages inside the security, gained monthly revenues and used that monthly income to finance several projects.

By 2005, MBSs became hugely popular among retail investors, Qualified Institutional buyers (QIBs), Governments, Pension funds, Hedge Funds, other investors, and even Banks in the United States of America (USA) & outside the USA. Other Nations & Banks in those Nations also capitalised on the idea and created MBS to sell them to investors, government institutions, etc.


Governments green-lit infrastructural projects while also providing support to government undertakings. They provided pensions, compensations, and damages using the funds raised from these securities. It got to an extent where the safest bonds - Treasury bonds (T-bonds) issued by several governments worldwide- became the least attractive option for people to invest in and for the government to raise funds.

Millions of investment companies were born across the world, and they have purchased these securities and started investing the money they received in other companies, ventures, and projects. Numerous people pooled all their life savings to get a piece of the action.

Even banks that created MBS purchased MBS from other banks to guarantee additional cash flow. This allowed them to increase their capital and perform the duty they were created for – giving loans, giving more loans, and giving more and more loans.

There was bliss for a little while before the bells rang, and everything descended into chaos.

Chaos. Chaos. Chaos.

Chaos. Chaos. Chaos.

For MBS to function the way it does, it requires a person who pays the mortgage on time, every time, regardless of the no. of loans that person may have taken. It is an extraordinary scheme created based on the credibility of the person taking the loan. The banks in the buildup to 2008 (both American and Global) offered so many loans to so many people that they eventually faced a severe shortage/dearth of people who had the credibility to pay back those loans.

To circumvent this problem, they devised unique solutions.

In the first stage, they started approaching people who needed a better credit score. The idea was this: If one person with a good credit score pays an ‘x’ amount of money (as interest & principal) - how many people with a bad credit score would it take to raise the same ‘x’ amount of money? Ultimately, if the amount of money an MBS generates remains the same (sum of all the principals and interests, i.e. the sum of all ‘x’ amounts of money paid by all the mortgages inside the MBS), why not extend the loans to people with relatively bad credit scores and continue to create mortgage-backed securities?

And this worked - they gave loans to people with relatively bad credit scores. Until they realised they could be more creative about how MBS was created.

If one person with a good credit score who has taken one loan pays an ‘x’ amount of money as principal and interest, how many persons with good credit scores and multiple mortgages would it take to generate the same ‘x’ amount of money?

Let me explain this with an example.

Let's say Tom has a good credit score, and they pay $5000 per month (principal and interest) as a monthly instalment for the mortgage taken. Let's say there’s another person by the name of Pete who has four mortgages to their name and who pays $10000 as mortgage payments. If Tom's Mortgage Loan and Pete's Mortgage Loan are bundled together in the same security - they generate $15000 monthly instalments. Now, let’s say another person's mortgage is also bundled with Tom & Pete's. If Tom or Pete can't pay the amount fully on the date of payment, and if the other person pays and if the total is still coming out to be $15000 - then they can sell that particular MBS (in which Tom, Pete & the other person are present) as an MBS that is generating $15000 per month.

As if this was not chaotic enough, they started schemes that allowed people to pay as & when they had the money to pay (Variable Payment Dates Scheme) - people can pay their monthly instalments on the dates they want to pay. In the end, the banks managed to provide the money that was guaranteed by making sure the final pay for the investor remained the same.

As if this was not chaotic enough, they started allowing to pay different amounts than what they initially agreed to pay (Option Pay Adjustable Scheme). In the end, the banks managed to provide the money that was guaranteed by making sure the final pay for the investor remained the same.

This incentivised people to take more loans, purchase multiple properties, and pay the loans whenever they wanted to and however much they wanted to. All of this allowed Banks to create different types of MBS - one with all the mortgages with good credit scores (prime mortgages), one with a mix of good and bad credit scores and risk (sub-prime mortgages) and one with extremely risky (people with more loans and less credible scores). The system was fine-tuned so that the MBS holder (prime MBS or Sub-prime MBS) kept receiving the money periodically, without fail.

A mortgage-backed security (MBS) is a security (like a bond) comprising thousands and thousands of mortgages bundled together onto one piece of paper. Whoever owns the security gets all the principal & interest from all the mortgages inside the security, and in the 2000s, after Lewis Ranieri created MBS, people started purchasing them by paying an exorbitant amount (calculated by adding the principal and the interest that the Bank is owed to receive).

The reasons for the success of MBS were twofold. One - who wouldn't want a guaranteed income source that will not stop providing money periodically? Two - MBS is better than taking debt (which involves incurring liability, thereby increasing the costs associated with the risk of failure) or selling company shares to strangers (which inevitably involves diluting control to unknown owners). Every player that purchased mortgage-backed securities, consisting of tranches of mortgages inside the security, gained monthly revenues and used that monthly income to finance several projects.

By 2005, MBSs became hugely popular among retail investors, Qualified Institutional buyers (QIBs), Governments, Pension funds, Hedge Funds, other investors, and even Banks in the United States of America (USA) & outside the USA. Other Nations & Banks in those Nations also capitalised on the idea and created MBS to sell them to investors, government institutions, etc.


Governments green-lit infrastructural projects while also providing support to government undertakings. They provided pensions, compensations, and damages using the funds raised from these securities. It got to an extent where the safest bonds - Treasury bonds (T-bonds) issued by several governments worldwide- became the least attractive option for people to invest in and for the government to raise funds.

Millions of investment companies were born across the world, and they have purchased these securities and started investing the money they received in other companies, ventures, and projects. Numerous people pooled all their life savings to get a piece of the action.

Even banks that created MBS purchased MBS from other banks to guarantee additional cash flow. This allowed them to increase their capital and perform the duty they were created for – giving loans, giving more loans, and giving more and more loans.

There was bliss for a little while before the bells rang, and everything descended into chaos.

As if this was not chaotic enough, the banks got more creative with all the unsold subprime mortgage-backed securities & the sub-prime assets inside that MBS. They decided to bundle all those ‘unsold’ subprime mortgage-backed securities and create another instrument (named – Collateralized debt obligation – CDO) comprising mortgages that make up the ‘unsold’ subprime mortgage-backed securities and sell them. The idea was to combine a bunch of low-yield and high-risk mortgages (low-yield & high risk because it has a lot of people with bad credit scores and did not pay regularly or as required) and make an instrument that is high-yield and high-risk.

As if this was not chaotic enough, the Banks started filling the tranches in the Prime mortgage-backed securities with unsold sub-prime mortgages that are present and began selling them as sub-prime mortgage-backed securities, which are high-yield with moderate risk.

In theory and the real world, it worked like a charm. Prime Mortgage-backed securities were sold, subprime mortgage-backed securities were sold, C.D.O.s were sold. And all of them yielded high revenues with different risk rates. And any unsold security/mortgage was repacked into another high-yielding instrument to be sold to the investors.

Credit rating agencies, which are supposed to understand the risks and rate these securities appropriately for the return they would give the investor, were pushed into a position NOT to rate them correctly. This was so because they were either bribed or individuals in the agencies themselves purchased the packaged securities sold by the bank to have a constant income stream.

The Securities Regulator – The Securities & Exchange Commission (SEC) of the USA, was, justifiably, under pressure to not interfere with a mechanism that seemed to work perfectly. It faced budget cuts, for the U.S. Government focused on using the American people's money in required projects instead of providing it to a regulator whose job is to regulate a golden duck.

The trend followed across the globe. The more the banks repackaged the mortgages to create high-yield securities, the more the credit rating agencies defaulted on their obligations, the more the regulator laid back, the more the people (natural & legal) that purchased the securities, the more they financed several projects. The more they financed several projects, the more they relied on mortgage-backed securities for cash flow and periodic finance instead of the conventional way of funding.

Even if they did rely on traditional ways of financing from the banks for massive projects that demanded transfer of funds from the financial institutions down the line, those funds were connected to the MBS and other securitised assets providing money to such a financial institution.

What everyone saw was a pyramid. They failed to see that it was a pyramid built on water.

A Pyramid on Water:

A Pyramid on Water

What happens when an institution's primary/predominant source of income becomes an asset connected with an individual's ability to pay their loans? And what happens when the Banks become greedy and lend money at the expense of credibility?

What happens when investors stop receiving the money from the MBS and call the Banks for clarity? What happens when the banks knock on the lenders' doors only to realise that they do not have the money to pay back all the loans or the ability to do so?

What happens when too many people default on payment of their multiple loans on a single property, various loans on numerous properties, or multiple loans on a single property? What happens when everyone wants to sell their property, gain money and pay back their loans to the bank?

What happens when a company/government, using the money it raised through this instrument, enters into several agreements to finance different long-term and short-term projects and fund other activities at a macro level?

What happens to all the companies awaiting income through the MBS they own and entered into legally binding contracts centred around them receiving timely income?

What happens when the whole world relies on one instrument for financing and survival, and that instrument collapses?

What happens when a pyramid is built on water?

Every nation, every company, every investor, every investment, every project, every undertaking, every agreement, and everything that is even minutely connected with this instrument collapsed.

A generation forever destined to struggle, suffer from financial trauma, and be condemned to live in the aftermath of it all.

$2 Trillion of the global economy went up in flames. In the United States alone, more than 1.8 million companies involved in providing consumer services and products went bankrupt, and 8.7 million people lost their jobs.

Imagine the extent of damage in the remaining 197 Countries.

This is the story of how crazy the stock market is, how made-up the world is, and what would happen if people's hopes were commercialised. This is the worst the financial world ever created.

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