the 2008 subprime mortgage crisis was caused by a lot of things, but one of the big factors were these things called CDOs (collateralized debt obligation), which is a type of bond with a lot of mortgages in it.

if you buy say 1% of a CDO, you are loaning out money equivalent to 1% of the mortgage principal in it. the idea is to get your 1% investment back, plus interest as all these mortgages slowly get repaid. big banks started buying up a lot of loans, grouping them into a CDO, then selling them to investors and collecting commission.

these CDOs could be split into risk tiers. the tranche (tier) of the CDO that had the most consistent/quickest mortgage repayments were the safest, while the riskiest tranches had mortgages least likely to be repaid. these tranches made things very confusing, the documentation for CDOs were very complex and made it hard for people to truly understand what mortgages were inside these CDOs. (people did not read the docs)

lastly, there were ratings agencies that would grade these CDOs. obviously, better grades on these CDOs meant lower risk, and investors would rely on these ratings to drive their decisions. several issues here. one, CDOs were so complex that the experts at these agencies didn’t really know how they worked. even better is the fact that big banks would have classes teaching people at these agencies how to grade CDOs, and the big banks were the ones selling these CDOs. obviously, it’s in the banks’ interest to have higher ratings. two, there were a lot of fraudulent loans out there, and it would’ve take some real in-depth research to uncover them. that costs time and resources, which is expensive. three, these agencies are for-profit companies. these big banks shopped around for agencies to give them good grades on their CDOs the same way drug addicts shop around for doctors to prescribe them prescription grade opiates.

(slightly off track, but a large number of opiate addicts in the US are elderly people who were prescribed pain killers after a surgery/big accident/etc., then eventually can’t afford them because of healthcare costs, and switch to heroin instead because its cheaper.)

so what ended up happening is that mortgage lenders would then knowingly sell mortgages to people who had no chance of ever repaying them, because they could immediately sell this risk to big banks. big banks would then package the risk into a CDO, make it hard to understand what was inside them, and then sell these bad CDOs with theoretically good ratings but were actually just bundles of garbage tier mortgages and collect commission.

so logically people wanted a way to hedge against these riskier tranches, essentially insurance. this insurance came in the form of credit default swaps. you didn’t have to own these CDOs in order to buy insurance against it, so billions of dollars of credit default swap insurance was being bought on CDOs with only millions of dollars of assets inside. for example, if there was a billion dollar insurance policy with a 2% chance of paying out, insurance sellers would logically only hold 20 million dollars in order to cover that bet. This essentially meant that the entire CDO mortgage insurance market was on 50x leverage, kind of like 2017 coin margined Bitmex futures.

as a result, banks were selling billions of dollars worth of insurance because they believed that the housing market was unlikely to fail, not knowing that much of the housing market was being held up by terrible mortgages being repackaged as CDOs that were being graded incorrectly, perhaps intentionally. they also collected a lot of fees during every step of the process. smarter banks were then buying this insurance, correctly betting against these bad CDOs. the only issue is that the smarter banks were buying insurance from banks holding CDOs, and these banks were going bankrupt because their CDOs were worth about as much as ElonDogeMoon coin and thus couldn’t pay out the insurance they had sold. so essentially the smarter banks got the right answers on the group project, but because everyone else failed the group project they failed the group project too. and because the big banks are the whales of the US economy, the disaster spread outwards and collapsed the whole thing, and the Feds had to bail everyone out on taxpayer dime because it literally would’ve all went to zero.

so what is the takeaway?

beware bad money. one dollar is always worth one dollar, but not all dollars are the same. many such cases. think about where the value of your dollar is coming from. bad dollars metastasizing throughout an economy creates great systemic risk. invest in better dollars.

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