Photo by Jamie Street on Unsplash
Regarding the 2008 financial crisis, most people only saw on the surface that the Wall Street elites in the United States caused the collapse of century-old institutions such as Lehman Brothers, Fannie Mae, Freddie Mac, Bear Stearns, Ambac, MBIA, and others due to improper manipulation of derivative financial products. However, few truly understood how the crisis formed and eventually dragged the world down. What was the relationship with guarantee insurance?
Let’s go back to the time between 2000 and 2008 in the US banking industry. Mortgage lending to prime borrowers with real estate and good credit had already peaked, and it was almost impossible to find new borrowers. At the same time, the financing of real estate by the quasi-national entities Fannie Mae and Freddie Mac was also facing challenges. As a result, some people came up with the idea of lowering their standards and accepting financing from investors with lower credit ratings while relaxing the collateral requirements for real estate, allowing for second or even third mortgages. To increase the lending capacity, real estate valuation was also inflated using dubious methods to achieve personal performance goals.
However, after a few years of such reckless practices, the number of loan defaults in the banks increased. The losses from insufficient collateral became significant, causing great concern among investment banks. They were worried that the investment positions in subprime mortgages held in their portfolios would eventually turn sour. So they devised another scheme called CDOs (Collateralized Debt Obligations), which carefully packaged the subprime mortgage debts into a new financial investment instrument that resembled an inverted pyramid structure. It is estimated that the bottom layer of the inverted pyramid, the MBS (Mortgage-Backed Securities) with collateral, is only $0.5 trillion. On top of that, the second layer was expanded by those investment bankers into $0.75 trillion of CDOs (a mix of secured and unsecured debts, but still rated as AAA), and the third layer was further expanded into $50 trillion of CDSs (Credit Default Swaps). The top part is composed of those unquantifiable synthetic CDOs+CDSs.
However, how did those investment bankers who invented and issued CDOs (basket of asset-backed securities mixed with unsecured debts, known as Collateralized Debt Obligations) convince the credit rating agencies, who are usually highly discerning, to give their CDOs AAA ratings, allowing these products to be marketed globally and causing havoc worldwide?
They first approached “Guarantee Insurance Companies” such as Ambac, FSA, MBIA, and others, which were also rated AAA, to obtain credit rating guarantees for the CDOs worth around $2 billion, in order to provide assurance to potential buyers of the CDOs that in case of any issues, companies like Ambac would take responsibility. As a result, these CDOs were also rated AAA. They then approached credit rating agencies such as S&P, Moody’s, Fitch, etc., with historical data showing that the default rate of insurance products had never exceeded 10% in the past century. The investment banks argued that by using these AAA-rated CDOs as collateral, they could increase the issuance of these CDOs to $20 billion (since 10% of the CDOs had guarantees), and the rating of the $20 billion batch of CDOs would also be AAA, as the default rate of insurance products had never exceeded 10%. However, the credit rating agencies were not easily convinced, and after several rounds of negotiations, they agreed to give AAA ratings only if the investment banks provided an additional $2 billion in cash as collateral, raising the percentage of collateralized portion to 20% of the $20 billion CDOs. Thus, the Pandora’s box was opened.