Causes of Financial Crises: Human Nature or the Thrill of the Game

People have always wanted to be rich and well off - it is a natural tendency and a human trait. But what’s different nowadays is that we live in an era where people seem to want to get very rich and very quickly. Bankers, who have always been known to be opportunists and greedy, did not waste any time to capitalise on this desire. They created clever ways to attract as many players as possible to the game of investing, or more correctly the game of leveraging, since the more players they have the more money they can make. With a little help from the US Federal Reserve, they swiftly seized the opportunity of the dotcom crash and the terrorist attack on the United States in March and September of 2000 to attract virtually everyone into their game of investing, particularly home owners. The game ended with the financial crisis. In very rudimentary terms, here is how it all happened.

Years ago, investors traditionally bought Treasury Bills from the US Federal Reserve for an acceptable return on this safe investment. But in the wake of the dotcom bust and the September 11th attack on the United States, Federal Reserve chairman Alan Greenspan lowered the interest rate to a historical low of 1 per cent in order to stimulate the economy. This caused many traditional investors to shop around for a better return on their investments.

Though a low 1 per cent interest rate was bad for investors buying US Treasury Bills, it was great for bankers on Wall Street. These bankers can now borrow money from the Feds very cheaply at a low 1 per cent interest and lend it out at higher rates. The trick was to create an investment game with as many players in it as possible in order for bankers to loan them their borrowed money to invest or play with. Once they came up with the idea of the game, they went crazy borrowing money and overleveraging. Not only did they borrow money at very cheap prices from the Fed but also from Japan, China and the Middle East as well.

Leveraging is lending more money than that which is available. It is a form of borrowing money to invest it. And when borrowing money is so cheap and the return is so profitable, leveraging actually makes good business sense. Wall Street bankers made incredible amounts of money through leveraging.

When traditional investors saw how investment bankers profited greatly from leveraging, they too, quite naturally, wanted to do the same, i.e., borrow money and invest it through leveraging. The problem was that they were not bankers, and hence could only borrow but not lend money. But Wall Street bankers, who were looking for more investors to make more money, came up with a simple idea that would allow traditional investors to borrow and lend money just like investment banks would by connecting them to home owners through mortgages. The idea in simplified terms is as follows.

A family wants to buy a house. A mortgage broker connects the family with a lender. The family buys the house and carries a mortgage, and the broker makes his commission. The lender then sells the mortgage loan to an investment banker for a fee. The investment banker classifies the mortgage loan into one of three risk categories: “safe”, “somewhat safe”, or “risky”. He then calls it Collateralized Debt Obligation (CDO) and sells it back to investors and other lenders. Investors are now investing in CDOs that they are buying from investment bankers and making much higher returns than the 1 per cent of the Treasury Bills. The rate of return of these CDOs varies according to risk. The “risky” CDOs have the greatest return but also carry the greatest risk, and the “safe” CDOs have the lowest return but carry the lowest risk. To make the “safe” CDOs even safer and more sellable to risk-avert investors, banks oftentimes insure them for a small fee called “credit default SWAP”. CDOs were also made that consisted of tranches of mortgages of various risk levels. Only a small percentage of the riskiest mortgages were contained in the package. The investment banks would apply some faulty probability models to the risk and, thanks to cooperative rating agencies, present them as low risk AAA graded securities. Investment banks and hedge funds used leverage as high as 100:1 against their working capital creating CDOs, CDOs squared (CDOs of CDOs), CDOs cubed (CDOs of CDOs squared) and other Ponzi-style investment schemes that ultimately found their way into every nook and cranny of the investment world, from Norwegian fishing villages to pension funds.

So far, the game seemed to have worked well for everyone involved. The family was a happy “home owner”; the mortgage broker was making nice commissions; the lenders were charging nice fees; with mortgage loans categorised and rated by professional rating agencies according to the risk they carried, investment bankers were able to sell all of them making billions in the process; and finally, investors were so pleased with the performance of these CDOs and wanted more of them to make more money.

But now there were no more mortgages to sell since almost everyone that qualified for a mortgage already had one. Yet both investors and bankers wanted to continue making money through creating more mortgages and more CDOs. To create more mortgages, lenders started lending to the less-responsible home owners. They called these loans “sub-prime mortgages”.

Mortgage lenders didn’t care if the home owner defaulted on the loan because they passed the mortgage paper on to the investment banks. The investment bankers didn’t care if the owner defaulted because they passed the mortgage paper on to some unsuspecting client. The creditworthiness of the borrowers and the terms of loans quickly became outlandish. Dubbed “Liar Loans”, money was awarded to people whose fabricated loan applications were never verified. Conditions of the loans might include money awarded to the borrower at 125 per cent of the home value with no down payment on the property. And this was the turning point of the game.

Home prices could no longer appreciate with the easy credit and began to fall in value. The economy slowed as home building slowed and people began to lose jobs as the economy contracted. Mortgage loans went into default and this began to affect the stream of premiums promised on CDOs and other mortgage backed securities. What would have been a normal cyclic slow down turned into a crisis when the world discovered the extent of Ponzi schemes where layer upon layer of securities were dependent upon the soundness of the layer above them in the scheme and the mammoth leverage used by the investment banks to create the securities and pump them into the world’s financial system.

Just like in the “hot potato” game that children play, where a hot potato is tossed between players and a player looses and is eliminated from the game if caught with the hot potato in his hands when the music stops, the investment banker was now holding a box of worthless houses, a bomb ready to explode. The banker tried to sell it but nobody wanted to buy it. Investment banker was now panicking since he borrowed billions to buy this bomb and he could no longer sell it or get rid of it to pay his loan back. But he was not the only one. Thousands of the investors bought thousands of these bombs. The game was over, many investors went bankrupt and the whole financial system was frozen and almost completely imploded.

Whatever the exact reason(s) or cascade of events that led to the crisis, one thing that will never cease to exist nor change is the human drive for more and man’s unwavering quest for creating ingenious ways to get there. Or, it may all be for the thrill of the game.

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