In the middle of around 2006, the housing market first showed signs of slowing and defaulting. The housing market was, up until then, one of the safest markets for investments. Top banks of the USA believed that nothing could ever crash the housing market until a few ordinary investors observed that the US housing market could crash, and that is how the story begins.
If you were into investing in real estate, you would be a millionaire back in the day. Real estate was a market with the highest returns on investment. Around the late 1990s till about the early 2000s, housing prices around the country had witnessed an ongoing surge. In the 1990s, under the Raines administration, Fannie Mae demanded that lending agencies lower their standards when giving a loan and that subprime borrowers pay a higher interest rate. If a mortgage borrower could not successfully pay the mortgages to the bank, all the bank had to do was sell such mortgages to Fannie Mae. In a market where demand was already outstripping supply, Fannie Mae and Freddie Mac created a need for subprime mortgages leading to a surge in demand for houses. Even though people did not have a spike in their household income, more and more people could now afford houses.
The commercial banks must have sufficient capital, but because of subprime mortgages that defaulted, banks could not create further credit in the market. So in the 1980's the investment bank Salomon Brothers devised a scheme of converting the loans into bonds and selling these bonds to some third party investor. The loan is removed from the banks' balance sheets and reaches into a Special Purpose Vehicle(SPV) in the form of a bond. The SPV issues bonds to its investors. This procedure is called securitisation, and the securities created were called Collateralised Debt Obligations(CDO). A CDO is collateralised security backed by a pool of fixed income assets. A CDO comprises tranches having guarantees of different degrees of risk ranging from AAA(safest securities) to BBB(toxic waste). These lowest tranches consisted of subprime loans and were offered to customers with low credit ratings. The interest charges were higher to offset the increased risk. With high profit yielding subprime mortgage-backed securities and the belief that the housing market would not crash, CDO's spread throughout the international financial markets like wildfire.
Soon after, the US housing bubble pushed inflation up; the interest rates had increased, borrowers were unable to repay the mortgages. The borrowers started defaulting on their repayments. The demands for CDO's started reducing, and instead of writing them off, the bankers, in lieu of earning maximum profits, started backing the bonds, which was worth next to nothing. The irony here is the customers were effectively their own employees. As more houses came into the market, it pushed down the house prices, the face value of the property had become way lower than their mortgage payments.
Credit Default swaps(CDS) are insurance-like contracts that cover the loss of securities in case of a default. The buyer of CDS will pay a premium periodically in return for being covered. With the growth of CDO's, CDS were in high demand to protect in case of a default. The CDS market is highly unregulated, and usually, the deals happen over the desk or telephonically between investor to investor. The banks and financial institutions considered it free money because they were confident that the housing market wouldn't collapse. The CDS were written on subprime mortgage securities. The speculators bought and sold trillions of such insurances. AIG and Bear Sterns nearly collapsed due to the investments they had made in CDS. When the housing market collapsed, the banks were under pressure to repay the investors in CDS. The Fed didn't let Bear Sterns enter bankruptcy because the trillions of dollars of CDS would wipe out from its books. For similar reasons, the Fed bailed out AIG. CDS which were easy money for banks, ended up being the very reason for the debacle of the financial market.
The CDS market was highly unregulated, and the banks gave in to their greed for easy money coupled with overconfidence that the housing market would never crash. Banks faced terrible losses to the point of insolvency. People lost their jobs and homes, leading to an extreme financial crisis. The miscalculation of risk in the CDS and the lenient collateral requirements lead to CDS being profitable and in excess demand. Thus, when the housing market crashed, and mortgages defaulted, large portions of CDS remained in many financial institutions and insufficient capital to cover these losses, which ultimately resulted in the financial crisis.
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