During the recent financial crisis, billions of dollars were evaporated and the livelihood of many were greatly affected.
Having personally seen some people deeply affected by it, I became compelled to bring the little knowledge I have about this crisis to light.
As many of you know from my previous articles, banks have a fractional reserve system that allows them to lend $10,000 for every $1000 in the bank, earning net interest payments for the loans.
This allowed banks to earn huge profits easily.
However, as time passed, bankers got more greedy and wanted more profits.
In June 1983, smart bankers found a way to increase earnings significantly by securitising mortgages and selling them as collateralised debt obligations (CDOs).
In simpler terms, mortgages were bought from lenders, arranged in groups and bonds were issued on those groups.
Bonds are certificates of debt issued by governments or corporations guaranteeing payment of the original investment plus interest by a specified future date.
The essence of bonds can be seen in the form of your IOU with the bank.
For example, when you go to the bank for a loan, you are selling a bond to the bank where it lends you money (your debt) and you pay it interest before you repay the loan at a specified future date.
Initially, these CDOs were not very popular because they were little-known and unprotected.
However, when rating agencies (like Moody's, Standard & Poor's) rated them and investment firms (like AIG, Fannie Mac, Freddie Mac) insured them with credit default swaps, they became very popular and people were misled into buying these risky financial instruments.
Credit default swaps are credit derivatives between two parties where one makes periodic payments to the other and receives the promise of a payoff if a third party defaults.
As you can see here, swaps are different from insurance as they are not backed by money but only "promises".
As demand for CDOs rose, banks had to supply more mortgages to meet this demand.
Here being led by greed, banks now granted mortgages to people with low credit ratings.
This continued until these subprime borrowers couldn't make their monthly payments as interest rates rose during mortgage resets, breaking the last straw and sparking off the financial crisis.
Here, I believe many of you can see that the root of the crisis is the fractional reserve system as banks lend out money they don't have, causing the gradual accumulation of toxic debt (loans to subprime borrowers).
As banks could not receive interest payments from the subprime borrowers, they couldn't earn profits to cover their losses.
Investment firms like AIG and Freddie Mac that insured these mortgages also fell because they did not have enough money to pay the banks who granted the mortgages.
After this, the rest is history because as you know, they were bailed out by free taxpayers' money for their mistakes.
Being short-term solutions, I do not think that bailouts can solve these problems in the long run because it will encourage greater fiscal irresponsibility in the big banks.
The rules of money here have changed long ago and the economy has evolved after each crisis.
Now, I believe we should keep up with this evolution to adapt to new changes.