A Great Recession Glossary and Condensed Explanation

Subprime Mortgages, Side Bets, and the Great Recession

The causes of the Great Recession were subprime adjustable-rate mortgages, and speculation using financial instruments that leveraged the actual market a thousandfold. In other words, greed and fraud. The linked Glossary below allows you to read and understand this bare-boned explanation of the greatest economic collapse since the Great Depression. You can use your browser back arrow to return to the explanation.

1. The housing bubble that preceded the crisis was financed with Mortgage-backed Securities (MBSs) and Collateralized Debt Obligations (CDOs) with higher returns than government securities and attractive risk ratings from credit rating agencies. The MBSs and CDOs were created by investment banks with mortgages bought from lenders, and lenders would use MBS and CDO payments to make more loans. [Subprime mortgage crisis, Wikipedia]
2. Subprime mortgage lending rose from a national average of 8% to 20% from 2004 to 2006. A high percentage of these subprime mortgages, over 90% in 2006, were adjustable-rate mortgages. [Subprime mortgage crisis, Wikipedia]
3. Housing speculation also increased, with the share of mortgages for other than primary residence rising from 20% in 2000 to 35% in 2006-2007. Investors in secondary homes, even those with prime credit ratings, were more likely to default than primary home buyers when prices fell. [Subprime mortgage crisis, Wikipedia]
4. In 2005 Dr. Michael Burry of Scion Capital, a one-eyed money manager with Asperger's syndrome, was studying subprime mortgage bonds and felt that the underlying mortgages were worsening in quality. He described this as "the extension of credit by instrument," meaning that an increasing number of home buyers could not afford standard mortgages, so lenders were dreaming up new instuments to justify giving them money. He asked Goldman Sachs and other investment banks to create a credit default swap to let him bet against adjustable rate mortgage-backed CDOs with higher interest rates due in 2007. [The Big Short, Michael Lewis, 2010, pp. 26-31] This type of credit swap eventually became known as the synthetic CDO.
5. Mortgage lending standards continued to drop and higher-risk mortgage financial instruments were created. The ratio of household debt to disposable income rose from 77% in 1990 to 127% by the end of 2007. [Subprime mortgage crisis, Wikipedia]
6. During this time the underwriting of subprime mortgage CDOs by the rating agencies (Standard & Poor's, Moody's, and Fitch) has been described as "catastrophically misleading." At the same time the supposedly independent agencies received fees from the investment banks. [Subprime mortgage crisis, Wikipedia] S&P did not have loan-level data on the CDOs because the issuing banks refused to provide it. "S&P was worried that if they demanded the data from Wall Street, Wall Street would just go to Moody's for their ratings." [Steve Eisman, The Big Short, pp. 170-171]
7. Synthetic CDOs grew in the mortgage-backed securities market because they were cheaper and easier to create than traditional CDOs, which required actual home sales with mortgages to bundle, and could not keep up with demand. Synthetic CDOs jumped from $15 billion in 2005 to $61 billion in 2006, becoming the most common CDO in the US with a value of $5 trillion. [Synthetic CDO, Wikipedia]
8. As adjustable-rate mortgages began to increase their interest rates and monthly payments, mortgage delinquencies soared. [Subprime mortgage crisis, Wikipedia]
9. Because the credit default swaps in synthetic CDOs were not regulated as insurance contracts, companies selling them were not required to maintain sufficient capital reserves. Demands for settlement of hundreds of billions of dollars of credit default swaps issued by AIG, the largest insurance company in the world, led to its financial collapse. [Shadow banking system, Wikipedia]
10. "A bank with a market capitalization of one billion dollars might have one trillion dollars' worth of credit default swaps outstanding. No one knows how many there are! And no one know where they are!" [Steve Eisman, The Big Short, p. 263] By 2012 the total value of synthetic CDOs had dropped from $5 trillion to $2 billion. [Synthetic CDO, Wikipedia]
11. The liquidity crisis led to the IndyMac and Lehman Brothers bankruptcies, the Federal takeover of lenders Freddie Mac and Fannie Mae and insurer AIG, the sale of Bear Stearns to JP Morgan Chase and Merrill Lynch to Bank of America, and the loan of billions of dollars to Citigroup, Bank of America, JP Morgan Chase, Wells Fargo, Goldman Sachs, Morgan Stanley, and others. [Financial crisis of 2007–2008, Wikipedia] and [Troubled Asset Relief Program, Wikipedia]
12. The US Financial Crisis Inquiry Commission reported its findings in January 2011. It concluded that the crisis was avoidable and was caused by:
    • widespread failures in financial regulation, including the Federal Reserve's failure to stem subprime mortgages;
    • dramatic breakdowns in corporate governance, including financial firms taking on too much risk;
    • excessive borrowing by households and Wall Street;
    • government officials ill-prepared for the crisis, lacking a full understanding of the financial system they oversaw; and
    • systemic breaches in accountability and ethics at all levels.
    [Financial crisis of 2007–2008, Wikipedia]

In 2010 the Dodd–Frank Wall Street Reform and Consumer Protection Act was passed. Although studies have found Dodd–Frank has improved financial stability and consumer protection, attempts at deregulation continue. In June 2017, the House passed the Financial CHOICE Act which would roll back many of the provisions of Dodd–Frank. The Senate has been considering its own bill since.

Great Recession Glossary
Collateralized Debt Obligation (CDO)	A structured, asset-backed security, notoriously mortgage-backed. A CDO pays investors from the cash flow of the assets it owns. The CDO is "sliced" into "tranches" based on quality. If some loans default and the cash flow cannot pay all investors, those in the lowest tranches suffer losses first. Return varies by tranche, with the safest receiving the lowest rates and the riskiest receiving the highest. Typical tranches are AAA, AA, A, and BBB. [Collateralized debt obligation, Wikipedia]
Credit Default Swap	An agreement that the seller will pay the buyer in the event of a reference loan default. The seller of the credit default swap insures the buyer against the default. Created by J.P. Morgan in 1994 for hedging against losses, it has now become a huge, opaque, and unregulated market. [Credit default swap, Wikipedia]
Derivative	A financial instrument whose value comes from the value of its underlying entities, such as an asset, index, or interest rate, as opposed to a cash instrument whose value is determined directly by the market. Derivatives can be exchange-traded or over-the-counter (OTC). [Financial instrument, Wikipedia]
Financial Instrument	A monetary contract between parties. Examples range from simple bonds or stocks to complicated derivatives like futures, options, and swaps. [Financial instrument, Wikipedia]
Mortgage-backed Security (MBS)	A security whose value is based on a specified pool of underlying home mortgages. [Mortgage-backed security, Wikipedia]
Security	Any financial instrument that allows trading of a financial asset. [Security (finance), Wikipedia]
Structured Financial Instrument	A security designed to transfer risk. It may increase liquidity or funding for a market like housing, transfer risk to the buyer, permit a financial institution to remove certain assets from its balance sheets, or provide access to more diversified assets. [Structured finance, Wikipedia]
Synthetic CDO	A CDO using credit default swaps and other derivatives. It is sometimes described as a bet on the performance of mortgages or other products, rather than a real asset-backed security. The value is derived from premiums paying for "insurance" on the possibility that some "reference" securities will default. The insurance-buying "counterparty" may own the "reference" securities and be hedging the risk of their default, or may be a speculator betting they will default. [Synthetic CDO, Wikipedia]