The Subprime Crisis of 2008 (Part 2) The Economics Lesson

I’m assuming you’ve already read part one, so this section about the 2007-2008 subprime crisis should make more sense to you.

The Subprime Crisis of 2008 (Part 2) The Economics Lesson

A few key points that you will learn from this story:

  • Goldman Sachs Buys the Subprime Idea
  • The Rise of Subprime Loans
  • The Collapse of Lehman Brothers
  • Too Big to Fail

Read the part 1 here.

Goldman Sachs Buys the Subprime Idea

Goldman Sachs paid over a billion dollars and bought the whole idea, patent included. Then they started rolling it out in America. They went to banks everywhere and didn’t do anything else but package these salamis, creating all sorts of products, like CDS, CDO, and so on.

And they kept selling these bundled mortgages until there were no non-performing mortgages left. But pay attention! Don’t think these bundled mortgages were bought by ordinary people.

They were bought by investment funds, pension funds, mutual funds, and, little by little, even by the banks themselves. That’s right—the banks packaged their own non-performing loans, made them into “edible salami,” and sold them off.

But on the other hand, because this product was becoming more and more attractive, you have to understand—Société Générale launched this product at 1 dollar in 1998, and before the 2008 crisis, at its peak in 2007, the price had reached 1,800 dollars. So, the rise from 1 dollar to 1,800 dollars happened in just 10 years.

What did Goldman Sachs do? After running out of all the mortgages, they said, "This process needs to keep going."


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The Rise of Subprime Loans

And how could it continue? Well, I’m out of non-performing loans to bundle with the good ones, so I can’t make any more salami. No problem! If I don’t have rotten meat, I’ll invent it myself. And that’s how they invented subprime.

When you go to an American bank, you’re categorized as either a prime client or a subprime client. A prime client is someone with an income, a salary, some assets, maybe a house, and they can borrow money much more easily. A subprime client, on the other hand, is someone who has nothing.

That’s how they created the infamous NINJA loans, where NINJA stood for No Income, Job, or Asset. Meaning you had no salary, no job, no income, no assets, nothing at all. And yet, they would still lend you money.

Real estate brokers started selling half-a-million-dollar homes to Mexicans—maids, or bus drivers—Americans, people down on their luck, even beggars off the street could suddenly buy a $500,000 house without putting down a single penny, except these were for massive amounts.

As soon as you created these subprime loans, you bundled them with prime loans, made your salami, and things kept getting better and better. This continued until around 2003-2004, when the old non-performing mortgages finally ran out.

And this went on until July 2007, when, in some small courthouse in middle-of-nowhere America, a judge had to decide whether a house should be put up for forced sale and how the money would be split.

The house, which had been bought but couldn’t be paid for, sold for, let’s say, $100,000. The judge said, “Alright, let’s see who the creditors are.

You had first-tier creditors, second-tier creditors, and so on.

And sitting there in the courtroom were about 30 people. The judge turns to one, “Who are you here for?” “Oh, I’m representing such-and-such investment fund.” “Okay, how much are you owed from this $100,000?” “$20,000.”

Next person, “$30,000.” Another one, “$50,000.” Then, “$70,000.

By the time they totaled everything up, all the creditors combined were owed $7 million. But the house wasn’t even bought for $7 million!

The artificial inflation, driven by trading and speculation on these salamis, had blown the prices up so much that the chunk of salami tied to the bad mortgage was now worth more than the actual house.

And we’re not talking about some luxury villa here. We’re talking about a one-bedroom shack in some small town—can’t remember if it was in Arkansas or Ohio. But anyway, that was the moment things started to unravel.

And there just happened to be a Wall Street Journal reporter sitting in the courtroom that day.

When the reporter saw what was happening, they blew the whistle, saying, “How is it possible that a house sold for $100,000 has $7 million in loans behind it, when it was never worth anywhere near that amount?” Just some random house in a tiny town. And that, right there, was the beginning.


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The Collapse of Lehman Brothers

The biggest seller and creator of mortgages had to file for bankruptcy in less than a month. But no one cared. Nobody understood at that moment what the real situation was in the mortgage market.

Not to mention, these salamis had become all sorts of variations. The first ones, with 5% non-performing loans, were AAA, but they had reached a point where there were salamis with 70% bad loans that were BBB, and people were buying them cheap, hoping they’d eventually become AAA.

It’s just like what’s happening in the crypto market today, where you have the first virtual coin that shoots up, and then everyone follows it and copies it, along with 10,000 other coins—some built on blockchain, some not, some tied to Bitcoin or Ethereum, and some not.

And when the real estate market started to decline, things took a dramatic turn. Don’t forget, by doing this, Goldman Sachs and all the other banks were freeing up cash and liquidity. What did they do with the liquidity freed up from the central bank? They kept lending it.

To whom? It was simple. You could lend it to the cleaning lady, and she’d buy a half-a-million-dollar house. I would consider it a non-performing loan right from the start, with no expectation that she’d even make one or two payments.

I know it’s impossible for her to pay it off in full. But I mix it, package it, and create more. House prices went through the roof because as long as there were no more forced sales and no problems on the surface, prices were skyrocketing.

On top of that, people were betting on how much the prices would rise. There were options on CDOs, CDSs, and so on. A whole frenzy of derivative products on something that was already a derivative. So, we’re talking about derivatives of derivatives.

They even created a synthetic future on these products. In 2007, the Federal Reserve tried to cut interest rates. They dropped them from 5% to 1% in less than a month and a half.

This calmed the market a bit until November, but then the market started bleeding again. By 2008, it was bleeding more and more, and all the big players realized that these salamis were now sitting in the hands of the banks through other derivative products.

In reality, the non-performing mortgages had been mixed together with the performing ones, and 90% of them ended up in the hands of Wall Street—the banks, investment funds, hedge funds, mutual funds, and, tragically, the pension funds.

After 2008, many people found themselves with no retirement savings left. This included the employees of Lehman Brothers, who were hit the hardest.

What happened next? Lehman Brothers collapsed—the only bankruptcy declared. The others merged and were bailed out by the U.S. government’s money.


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Too Big to Fail

They didn’t let the banks that took huge risks go down, like they let Lehman Brothers. There should’ve been another 20 big banks that collapsed. But instead, some of them merged with others.

Bank of America bought Merrill Lynch, J.P. Morgan bought Bear Stearns, and so on, and so on, creating even bigger banks. Banks so big that the famous phrase "Too Big to Fail" became a reality.

It means you're too big to be allowed to go bankrupt. And today, everyone wants to grow exponentially. Just like Elon Musk—he has no problem taking on massive loans, or look at BlackRock with a market cap of $130 billion, issuing $16 trillion in ETFs—$16,000 billion.

Because, if you’re so big and can cause a systemic crisis, of course, the state will come to save you. It’s exactly what the Greeks did.

They borrowed so much that, in the end, the European Union couldn’t let them collapse in the very currency they all share. That crisis probably won’t repeat itself.

The only one who paid was Lehman Brothers and their CEO, Richard Fuld.

Everyone else got away clean, and many of them even walked away with golden parachutes—hundreds of millions of dollars to leave their positions in certain banks. And let’s not forget about banks like UBS in Switzerland, which still have skeletons in their balance sheets—hidden, under the radar.

If you carefully read the reports, you’ll see they still have subprime products from before the crisis. They keep moving them year after year, covering them up with whatever new profits they manage to make.

In my opinion, the next crisis might involve ETFs just like the subprime crisis did back then. ETFs have exploded in popularity, and all they do is fool people into thinking they’re holding a basket of stocks for much less money.

But we’ll talk about ETFs in another lesson. If you want a detailed and well-explained story about 2008 and the subprime crisis, you should watch a movie whose screenplay won an Oscar: The Big Short. You’ll see famous actors like Christian Bale, Brad Pitt, and Ryan Gosling.

The direction is remarkable, and the story is adapted from the book—novel, whatever you want to call it—by the American author Michael Lewis, who also wrote another interesting book called Flash Boys, about algorithmic trading systems run by computers.

Systems that now dominate 70% of daily transactions on Wall Street. I recommend the movie—it’s available on Netflix, and you’ll definitely learn a lot from it.

It’s not overly dramatized or romanticized; it’s actually quite realistic. Another important book about the subprime era is one written by a group of French authors about Société Générale and what I’ve been telling you about: Confessions of a Toxic Banker.


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