When a bank decides to buy a loan, there is an agency that says how risky the loan is, based on how likely it estimates that the loan is to be repayed. The assumption that the rating agencies made in order to calculate the risk is that loans are independent, meaning if you have 100 loans, and each one has a 50% chance to be repayed, then the chance of all the loans not getting paid back is 1/2^100, so that almost surely you will get at least 30% of the loans paid back, and most likely 50% of the loans.
This type of rating allowed banks to give home loans to whoever they wanted, without worrying about the ability of the person to pay it back, because they could put the riskiest loans together with other loans, so that they looked safe, because, what's the chance of all these loans failing at the same time?
But Goldman Sachs people knew that these weren't safe at all, they were just being misrated by the rating agency. The reason is that a lot of these loans were taken as the prices of real estate were very high, and if the prices would go down, it would make no sense to pay a loan which is worth more than the collateral, you would be better off just letting the bank take the house, and then buy it again at the new cheaper price. So if housing prices were to go down, ALL the loans would fail, and it wouldn't be a coincidence.
But then, instead of alerting the agencies to the rating issue, Goldman Sachs got these loans, went to AIG and said they wanted to take insurance against failure of these bundled loans, then they passed the loans on to other banks. The insurance would pay them back in case the loans would default. They figured they would make a ton of money, because they knew that those loans would fail when prices start going down. The insurance was cheap, because AIG was using the rating agency's estimates for the chance of failure of these loans, which was completely wrong.
But they weren't alone in doing this, a whole bunch of other financial people also realized this, and also went to AIG and bought insurance against failure of these loans. They were all thinking "boy, am I clever to have figured this out. When the loans fail, we're going to make a ton of money".
Then the loans failed, and AIG had to pay off all their insurance policies. But they had priced them too low, so they didn't have enough money to pay these off! Because they were using a wrong probability model, they never expected to have to pay so much. So AIG was going to fail, and then Goldman Sachs wouldn't get it's money. Those banks that were left holding the loans also were in a terrible situation, they were holding suddenly worthless assets that used to be worth billions of dollars.
But then instead of letting those firms go bankrupt, the government gave a ton of money to prop them up, by buying the crap loans. Instead of Goldman Sachs losing a ton of money when AIG failed, they made a ton of money. If the government had not stepped in, all these enormous financial firms would probably have collapsed, and I am not sure that this would be a bad thing.
Why wouldn't this be a bad thing?
Because they are enormous and stupid (obviously, this is an example), and if they were destroyed, the new firms that would replace them would be small and competitive. It's not like they produce cars, manufacturing, business, or ventures, would only be affected to the extent that capital is removed from the system, but this can be fixed by monetary policy, by giving smaller banks money from the Fed directly. The large investments firms don't do anything productive except siphon capital into their pockets, they are not a competitive industry.
Thanks. I overestimated their presence.
It would be catastrophic for many wealthy people, who would lose a lot of investment money, but this is not such a big deal for people who actually do stuff, under the condition that people can still get venture capital from venture firms and banks, with loose enough monetary policy. A loose enough monetary policy and you don't need any rich people at all.
The impact on wealthy folks would have been enormous, a lot of them would have lost everything. I am not trying to understate it. I remember when the house rejected the first version of the bank bailout, I was scanning the times, and a (probably) wealthy older guy asked me "What do you think of the rejection?" I said "I think it's great." He said "But do you realize how much money people are going to lose?" I said "Yes, it's fantastic". He then actually hit me (weakly), he sort of pushed me physically and left in a huff. It was on 116th st, outside Columbia.
The screening of borrowers' creditworthiness was such a great disaster.
The creditworthiness of the borrowers was not an issue at all, it's a ridiculous way of trying to shift blame to consumers. If the loan is worth more than the collateral, even Mr. Always Pays His Credit Card On Time will default, because that's the rational thing to do.
Yes. I see your point. Also I'd like to know your opinion on Ninja borrowers.
I don't know what they are.
NINJA - No Income No Job Also. I had read about them in early 2009. Such borrowers had created a lot of positive bounce in the real estate market. Of course it was just a fake bubble.
Oh, that's another case of blaming the consumer. The banks wanted as many of these loans as they could get, you can't blame the consumer, the banks were essentially paying them to make these loans, because the banks figured they were going to make money off of them later.
The individual consumers just did what was in their interest. They are not at fault at all.