How will you explain the 2008 financial

crisis to a teenager?
Please use easy -to-understand terms.

Alqama Pervez, Manager, Reserve Bank of India

Updated Aug 2, 2016
Remember the childhood game of Pass The Parcel (or Pass The Pillow)?

(Image source: wikihow)

The 2008 financial crisis was just a pass the parcel game, the only difference
being that the parcel was a financial time bomb that would take everyone down
once it exploded. And that is exactly what happened.

So, who were the participants in this game?

The general public (the innocent entity in the game, oblivious to the perils
involved)
The banks (your local, boring commercial banks)
The investment banks - Merrill Lynch, Lehman Brothers and others
The investment companies (another largely innocent entity in the game)
The insurance companies - American International Group (AIG) and others
What role does each of this entity normally play in an economy?
 The general public deposit their savings in the banks and borrow from the
banks. They also invest money in the products sold by the investment companies
(Mutual Funds, Hedge Funds, Pension Plans, etc) and buy insurance from
insurance companies.
The banks accept deposits and give away loans (home loans, car loans, personal
loans, corporate loans, etc).
The investment companies pool money from investors (the public and the
corporate houses) through their products (Mutual Funds, Hedge Funds, Pension
Plans, etc), invest that money in the financial market (shares, bonds, etc) and
share the yield with their investors.
The investment bankers link the investment companies to the banks and other
corporate houses.
Insurance companies insures anyone who wants to insure something, in return
for a premium.
When acting individually and under strict regulations, these entities are pretty harmless, or
in fact, quite useful for the growth of the economy. But in the early 2000s they began this
dirty game of theirs that ultimately threw the entire global economy into disarray.

What was the game? How did it all begin?

House Loans.

The game was all about housing loans. Under normal circumstances, a family that desires to
buy a new house approaches a commercial bank for a loan. The bank verifies the
application, sees if the family has the capacity to repay and a clear past record, and
sanctions the loan (a.k.a mortgage) The family repays the loan over a period of time and if
it fails to repay, the bank acquires the mortgaged house and the family is kicked out. The
bank sells/auctions the house and recovers its dues.

So far so good.

But in the early 2000s, the investment banks and the investment companies were sitting on
a huge pile of idle cash. The economy was dull and they had few opportunities to make big
money. But the mainstream commercial banks were doing pretty fine, coz the housing
market is never really down (houses are always needed man!). The investment bankers
thought why not join the banks in the real estate world and make use of their idle money to
makeerrr...more money!

The investment banks asked the commercial banks to sell them their mortgage loans.

Now why would banks sell their loans to someone?

Suppose, a mortgage loan is worth $500,000 with 10% simple interest to be paid over 10
years. Thus, at the end of 10 years, the bank gets $550,00 from the borrower. The
investment banker instead offers that the bank transfer (or sell) this mortgage loan to the
investment bank for, say, $530,000.

Why would the bank sell the mortgage at $530,000 to the investment bank when it is
supposed to get $550,000 from the borrower himself?
There is something called the time value of money. $530,000 right now is a lot better
than $550,000 after 10 years. It is, therefore, in the interest of the bank to accept the
investment bankers offer, which it eventually does.

So the mortgage gets transferred to the investment bank. It's now the investment bank that
recieves regular payments (loan repayment) from the home owners (i.e borrowers), or
acquires the house in case of a default.

Now we come to the next player - the investment companies, that were sitting on a pile of
idle cash too and were looking for investment avenues as well. As mentioned earlier, the job
of the investment bankers is to link the investment companies to investment opportunities.
The investment bankers called up the investment companies -

Invsmt Banker: Hey bro, we have some new investment opportunities, wanna try them?

Invsmt Co.: Sure, why not? What are they?

Invsmt Banker: They are calledummmmm Collateralized Debt Obligations

Invsmt Co.: Colled..what? Never heard of them

Invsmt Banker: Collateralized Debt Obligation.. They are cool man, just try them

Invsmt Co.: Are the returns good enough and the investment safe?

Invsmt Banker: Of course bro, they have got AAA ratings

Investment Co.: Great! Send them over then

*end of conversation*

And with this, the investment bankers passed on their mortgage loans to the investment
companies in the guise of the fancy sounding thing called Collateralized Debt Obligation
(CDOs).

The dirty game begins here.

To keep making more and more money, the investment banks need more and more
mortgage loans and for that, the commercial banks need to give away more and more home
loans. But there is an obvious limit to the number of well-to-do citizens in an economy who
can be extended a loan. You cannot lend to anyone and everyone, lest they default. But the
commercial banks thought, Hey, why do we care? Once we sanction a loan we pass it on
to the investment banks. It becomes their headache thereafter. Even the investment banks
would think on similar lines (We anyway gonna pass the mortgage to the investment
companies as CDOs, so why bother?).

With this, started the phenomenon of SUB-PRIME LENDING i.e giving away loans to
sub prime customers (customers who didn't really have the ability and/or the will to repay
the loan).
And if that was not enough, even the insurance companies (our 5th player) jumped into the
muck.

They introduced a new insurance product with, again, a fancy name - Credit Default
Swap (CDS). But these were less of an insurance product and more of
a betting instrument. Just like you put a bet on a horse in a derby race or on a team in a
football match, CDS were tools to allow you to bet on home owners (borrowers). You think
Mr. Donald has no capacity to repay the loan upon which he bought that new house
recently? You just bet on this via CDS. If Mr. Donald ultimately fails to repay his loan, you
win the bet?

Appalling, isn't it? But there's more to come.

Soon, the investment bankers themselves became the biggest betters! They
started betting against home owners; those home owners whose mortgage they were
themselves holding!! Which means, they knew that the mortgages that they are holding are
risky and low-worth. But why would they care? They were ultimately passing those
mortgages on to the investment companies as Collateralized Debt Obligations!

The bomb was up and ticking.

(Pardon the crude look of the doodle. I did not have access to fancier tools)

By 2008, home owners started defaulting enmasse. The betters were winning and the
betting company (actually the insurance company) losing. The American International
Group (AIG), the biggest insurance company involved in this, was on the verge of collapse in
August 2008. It had to be rescued by the US government. [U.S. to Take Over AIG in $85
Billion Bailout]. The general public that had bought other insurance products from AIG
suffered too.

With home owners defaulting in bulk, the mortgages held by investment banks and CDOs
held by investment companies became worthless. On September 15, 2008, investment bank
Lehman Brothers crashes and so does the stock market [Crash! Shares tumble as Lehman
Brothers collapses and fears grow]. And the Domino effect took down with it the entire
global economy.........

https://www.quora.com/How-will-you-explain-the-2008-financial-crisis-to-a-
teenager/answer/Alqama-Pervez-1