How Leveraging Triggered the Financial Crisis12/16/2020
Leveraging triggered the financial crisis because it created a system of creating money that could not be sustained.
What is Leveraging?
Leveraging is the process that allows creative financing of real estate transactions.
Some bankers at some of the world’s largest banks took a fundamental idea—the idea that money can be created on paper—and carried it too far.
Money Making Magic Out Of Control
In the Disney classic “Fantasia,” one of the most memorable episodes is the “Sorcerer’s Apprentice,” when the young sorcerer taps into magic he cannot control. One magical broom turns into an army of magical brooms and the young sorcerer cannot stop them.
This cartoon is powerful example of what happened with the banks. They used their money-making magic and then got greedy. Just as the sorcerer’s apprentice unleashed magic he could not control, the banks unleashed a money making process that got out of control.
Freedom From Banking Regulations
With new-found freedom from all kinds of post-Great Depression era regulations, some of the biggest banks threw caution to the wind, and created a dazzling array of paper instruments, which allowed them to make massive profits.
Credit Default Swaps, Derivatives, And Mortgage Securitization
The biggest investment and commercial banks created their own creative financing techniques, such as “credit default swaps,” and other such exotic “derivatives” designed to create money on paper. Then these paper assets were “securitized.”
Securitization is the process of taking a large number of individual loans and then pooling them together. This process of securitization can apply to any type of loan, such as automobile loans, when large numbers of individual loans are pooled together and sold as a bundle.
What Happens When Mortgage Loans Are Securitized?
If the loans are mortgages, this process creates “mortgage backed securities.”
If your mortgage is “securitized,” it is bundled with other mortgages in the form of mortgage backed securities. Very often, the bank holding your securitized mortgage sells interests in the pool, usually in the form of bonds.
Bonds are long term debt sold to investors by the banks. When an investor buys a bond, the investor is making a loan to the bank.
Why Banks Went Broke Making Money
Banks sell bonds to raise capital. In other words, the banks borrow money based on their “securitized mortgages.”
And just as many homeowners borrowed money they were not qualified to repay, the banks borrowed money based on “assets” that were worth far less than the value the bank claimed as the value of the bond.
This more than any other reason is why banks went broke making money. Some of the biggest banks, with the largest portfolios of securitized mortgages, also were most deeply in debt. They could not repay their loans to bond holders because so many borrowers had defaulted on the mortgages that were the foundation of the bank’s assets.
Creative Financing Run Amok Caused The Financial Crisis
Leveraged financing created a house of cards that began to collapse when borrowers could not pay their mortgages. The cascading effect of leveraging mortgage loans resulted in a profound crisis in the entire economic system. The basic cause of the global financial crisis was leveraging run amok.