Let’s take a trip back to 2008.
Remember when the housing market was collapsing–and with it the entire global financial system? If you’re too young to remember those days (they’re still vivid in my mind and the minds of many who lived through it), they were actually more terrifying than the darkest days of the pandemic. The thought of a global deep depression like the 1920s was real, and the implications of that–global poverty, increased social unrest, and a possible third world war–were not ridiculous risks to consider.
It didn’t happen, in large part because of very unpopular at the time bank bailouts and monetary stimulus that pretty much every economist and financier agree today were absolutely necessary, if odious. This resulted in many regulatory changes to make sure banks would never put the world in that situation again and, so far, it seems those regulations have worked well. Plus, this trial run for what to do in a major financial crisis also resulted in the framework used to effectively stop a financial disaster coming from the pandemic in 2020.
At the core of 2008 was a mismanagement of mortgage debt. But why was this so bad? And who exactly owned what during the chaos?
An important concept to understand is the capital structure, which you can think of like a pyramid. Those who have debt claims (creditors) are at the top of the pyramid, and those who have equity claims (owners) are at the bottom.
When an asset, such as a house or a company, has more debt claims on it than its actual market value, it is still technically owned by the equity holder at its fair market value, but if that FMV is 0 or below 0, they actually hold nothing. But at the time of bankruptcy (in the case of companies) or short sale (in the case of houses), debtors are made whole as much as possible in the order of their claims to the asset, which means some debtholders will get nothing as well.
Let’s take an example: I buy a house for $1m with a 100% mortgage from Bank A. I owe Bank A $1m on my house, which I technically own in a sort of theoretical way, but in all practical terms Bank A has claims on my for that $1m until it’s paid off.
Now let’s say I stop making payments; I’ve breached my contract with Bank A, which allows them to push for a judgment against me and force the house to be sold so they get their $1m back. The house sells, and Bank A gets their $1m.
But let’s say the house is worth less than $1m–say $900k. In this case, the bank can ask for ownership to be transferred to them and the house not sold, or they can force a short sale, get $900k, and lose $100k on the whole thing. In the 2008-2009 crash, banks often, but not always, did the latter.
This is simplified; in reality a $1m mortgage will be resold from Bank A to Bank B, Bank C, Bank D, Bank E, etc. as part of a collateralized debt obligation (CDO), so if there’s a default and short sale below initial mortgage value the risk of losses are spread across many banks.
What made the subprime crisis so bad is the derivatives built on top of the initial CDO–several CDOs were rolled together into a new asset that was then chopped up and sold to banks and funds, and then those were rolled up into a new derivative, and so on…to the point of abstraction where the bets were removed from reality by several levels, all of which multiplied the effect of a single default.
At the end of the day, legally the house was still owned by the homeowner on the privision that the homeowner would maintain payments on the house to the bank; failing that, the bank would force a sale of the house to a new owner, getting the proceeds from the sale to make the bank whole. And when these houses fell in value, the homeowners suddenly found out that the value of their ownership was zero.
This is a good lesson in the importance of learning the difference between legal and financial ownership; one can legally own something and leverage it with debt, and while that does not change legal ownership, it adds an extra layer of financial obligation that limits the real value and usefulness of ownership–but it does not lower the responsibilities connected to ownership. In some cases, owning something is really bad, but lending to someone who owns something is a much better deal (this is why we have debt and equity in the first place).
Understanding the capital structure helps you understand what happened in the Great Recession, and it also helps make the problem with the CDOs much clearer. This is a good example of how a fundamental understanding of the concepts of finance can make much more complicated notions (CDOs, CDO squared, MBS, interest rate risk, default debt cascades) so much clearer and simpler to grasp.