One Cause of the 2008 Financial Crisis

Nobody creates a strategic plan for system-wideof the 1980s savings and loan crisis) in the U.S. forced
catastrophes. Everybody forgot the lessons of howthem to shrink their balance sheets at the end of
portfolio insurance magnified the losses suffered onevery day.
Black Monday, October 19, 1987.Only JPMorgan Chase saw the danger. They began
In the 1980s everybody managing money took outunwinding their portfolio of mortgage-related
what was called "portfolio insurance." It wassecurities in October 2006.
software designed to track your portfolio ofBanks, hedge funds and other financial institutions
investments. If the market value of one went downaround the world had been buying up the MBS. If
by a certain percentage, the software would startthey didn't own some, they probably owned stock in
selling it to stop the loss.U.S. banks that did. Or they'd made loans to banks
For one fund, for one falling stock, this is a good idea.that did.
Cut your losses early.Plus, the world's financial institutions and markets are
But when every fund has this same plan, it meansinterconnected through off the books derivatives.
that when the entire market starts going down,Most of them are highly complex financial contracts
everybody starts selling. So the market kept goingdesigned to "manage" risk.
down.But remember, that these people think "risk" means
Therefore the software kept issuing more sell orders."price fluctuation" not "danger."
Forcing the market down even more.So they take out derivatives that arrange their
The Dow Jones dropped 22% in one day, andfinances so they will make a profit under almost all
automated portfolio insurance was responsible for afinancial conditions.
lot of the selling.I emphasize "almost all" because it's impossible to
If you're in a theater and a fire breaks out you knowremove "all" danger from this world we live in.
you should run for the nearest exit. What will you doTherefore, there's always a "highly unlikely" scenario
if hundreds of people are blocking your path? Nobodywhich, if it happens, will make the derivative
on Wall Street thinks about that.unprofitable.
Something similar happened with mortgage backedThese scenarios don't happen often, but when they
securities (MBS), collateralized mortgage obligationsdo, they cause enormous financial pain.
(CMOs), collateralized debt obligations (CDOs) andDerivatives are the financial equivalent of playing
structured investment vehicles (SIVs).Russian roulette with a gun with only one bullet and
They were sold to investors and institutions around99 empty (that is, safe) chambers. The odds are
the world as a safe way to increase their return onhighly in your favor, but if the one bullet is in the
investment.chamber when you pull the trigger, you'll still die.
In this case, the problem wasn't caused by massiveOn Wall Street, the damage from the crisis was
selling, because these securities are not liquid.dramatic. Not too long ago, Wall Street had five
However, their returns started dropping as largeinvestment banks that were like gods to the financial
numbers of home owners around the United Statesmarkets.
started missing payments on their mortgages andNow, Wall Street has zero investment banks!
going into foreclosure.In March 2008 two of Bear Stearns hedge funds
Nobody had ever seen so many American homefailed and it was bought out by JPMorgan Chase.
owners default on their mortgage debts, but neverIn September 2008 Lehman Brothers was forced to
before had so many unqualified people been alloweddeclare bankruptcy.
to buy houses despite no or low downpayments,However, also in September 2008, Goldman Sachs
unverified incomes and poor credit ratings.and Morgan Stanley were allowed to convert to bank
Once the situation started escalating, institutionsholding companies. And Bank of America was
holding the MBS bonds found their sales pricespersuaded to buy Merrill Lynch.
dropping. Mark to market rules (enacted in the wake