How We Got In This Mess
Phase one of a formula for disaster (Lewis): Take a thousand home mortgages. Rank them according the odds that they will successfully be repaid (and, yes, a few other things, but let's just keep things simple). Stack them up with the best ones on top and the worst ones on the bottom. Divide them into sections - tranches, in finance-speak - and sell the best ones off at a high interest rate and sell the worst ones at a lower interest rate. That's normal stuff. Now it gets interesting.
Take a thousand of the worst mortgages and divide them up the same way, only, since they're all bad anyway, don't really spend too much time figuring out which ones are the bad loans and which ones are the good loans. Pile them up and sell them the same way you did the first batch of one thousand loans.
Do you notice something? I'm sure you do. Since the second pile was composed of all bad loans, it is almost guaranteed that some will go bad. That's, basically, a given.
Now the second phase of our formula for disaster: Assume that residential housing prices will continue to rise - forever. It seems logical enough. We've got lots of history that says housing prices rise over time. We all know what happened. There was a housing bubble. Houses stopped rising in value. In fact, they crashed.
When the finance guys ran the numbers on that second pile of loans we were talking about, they estimated that the whole pile would collapse when three percent of the loans failed. Whoops. We all know what happened. Somewhere around eight percent of the loans failed. The pile of bad loans really fell down. Whoops, again.
Now, in the past, we would have just felt bad for the bond-holders and moved on.
Phase three of a formula for disaster: things get worse. Some smart person realized they could make even more money on the bad loans by insuring their holders, essentially insuring that loans would never fail at more than the three percent rate, let alone the eight percent rate. Since they were so sure of their financial numbers, they did something really smart: they leveraged their bets, big time (or maybe more than that - thirty times or so, actually). Whoops, again.
Put all this in one pot and mix and you have what we got: an almost guaranteed formula for disaster. The best part? Someone - maybe ten someones, actually - predicted all this failure and shorted the market for insurance company stocks, and bad bonds. They made billions. We lost trillions.
Ah, capitalism. Pretty cool, until it's not.
Reference
Lewis, Michael. The Big Short. Inside the Doomsday Machine. W. W. Norton & Company. 2010