WHY ENVY IS THE BIGGEST SIN??

The year was 2008 and the day was 29 August. John turned on the TV and saw all his life savings vanish in a matter of time. The S&P 500 (US index) had crashed 20% and hit a lower circuit. In the days to come, the markets fell by 69%. The 2008 crash is still considered to be one of the worst crashes in the history of markets. Why is it called so? What led to such a horrific crash? Why, Mr. Buffett says that the derivatives are products of mass destruction? Who should be blamed for this crash? Too many questions and too few answers. In this blog, we are going to discover the dark and greedy side of the markets and the people who fuel this greed. After reading this, you might give investing in the markets a second thought, but trust me, there are valuable lessons as well.

Before we begin, a quick disclaimer. Because the crash was so complex, this blog is going to be a long one and a bit boring. The exact combination you all crave. Let's dive in. 

After the dotcom bubble of 2000, Americans looked for new and safer products to park their money. Markets were not an option. The economy was badly hit, resulting in slower economic growth. Inflation was hovering around 3-4% and the interest rates were high. In order to kick start the economy, the Federal reserve (US central bank) decided to lower interest rates. When interest rates are low, borrowing becomes cheap, which leads to a one-sided rise in loan growth. Even in the US, 2 main reasons why Americans would opt for a loan are education and real estate. As the interest rates were lowered, individuals started taking loans in order to buy a house.

Suddenly, out of nowhere, everyone started taking loans to buy their dream house. Looking at the aggressive loan growth, the banks started offering various schemes so as to attract individuals to take a loan and build that dream house. The more loans these banks write, the more profits they suck in. The average holding period for houses fell from 2 years to 8 months, and later 4-5 months at the peak. Remember that real estate is one of the least liquid assets. Looking at this scenario, investment banks were like, why should banks have all the fun? IBs don't function like a normal bank. Their main work is to help companies raise capital and undertake mergers and acquisitions. 

Looking at the scenario, an investment bank came up with a product called the collateralized debt obligation or CDO. (CDOs are a type of asset backed securities that were developed to decrease the risk borne by the banks). What these banks did is that they collected all these loans and called them a pool of loans and further, sold these pools to investment banks. Investment banks further collaborated on different CDOs and sold them on the markets to retail investors. Now, an individual borrower would make his interest payments to these banks, but the banks have sold these loans to investment banks and investment banks have later sold these to retail investors in the form of debt. So, indirectly, the borrowers were making these interest payments to investment banks which served as interest income to CDO holders. 

SIMPLE WAY 
group of individuals took loan - bank gave loans - bank sold these loans to investment banks for some money - investment banks sold them to investors as a form of bond in open market. 

I paid my interest to bank - bank sold the loans hence the interest they collected from me would transfer it to investment bank - bank sold these to investors as a form of debt - hence gave that interest as interest on CDOs. 

Because of decreased interest rates and having no other asset class to park the money in, the US property markets skyrocketed. Now every individual wanted to buy a house, every bank wanted to underwrite more loans and every investment bank wanted to create more and more CDOs because all of these instruments fetched heavy profits. The problem with this saga was that it was driven by excessive greed. All these banks were ignoring individual credit scores. In the US, they are called the FICO scores. 

There was a time when banks started offering loans to people with no income or jobs. These loans were called ''The Ninja Loans". Everybody thought that the real estate market could never fall because, for the real estate markets to fall, borrowers had to stop making interest payments, which was impossible. The real estate market was considered to be "Too big to fail'. But since these banks had given loans to people with no income, the real estate market had to fall someday. 

One of the biggest culprits for this crash are the credit rating agencies. Credit rating agencies are supposed to rate the debt instruments that are issued by the issuers. The highest credit rating was AAA and the lowest was C. All CDOs had AAA credit ratings while inside those products were worthless crap. A credit rating tells us how secure the bond is? There were only 2 credit rating agencies. In order to protect their market share, these credit rating agencies gave AA or AAA ratings to these CDOs which were worth Z. 

But among these bunch of greedy people, there were few who had a rational mind and thought about the market bubble. One of the rational guys was Dr. Michael Burry. Mr. Burry bought a CDS. CDS stands for credit default swap. CDS works like an insurance contract. You will pay a monthly premium and the bank would protect you when the markets fall. Mr. Burry bought a CDS against CDO. It's like he bought an insurance contract against a pool of loans that were unsecured. So, when these borrowers' default on these loans, Mr. Burry would get a claim because he had protected himself. And what these rational people were expecting occurred on the morning of 29 August 2008. The US markets fell miserably, eroding trillion and trillion of dollar worth of global wealth. 

In conclusion: greed is good, but excessive greed can kill you. The banks were making huge profits when they were underwriting loans but because they wanted exorbitant profits, they came up with some innovative product hoping it would satisfy their dream. They also ignored their credit scores. Always remember, most of the innovations in the financial world are miserable. Look at Crypto, look at NFTs, CDOs and everything. Also, to keep yourself safe from these kinds of foolish bubbles, always remember to stick to your circle of competence. Another thing is that such kinds of crashes are rare but when they occur, make sure you bet heavily because one of the greatest investment opportunities arises when the markets are at an-all-time low. I would urge you all to watch "the Big Short". The movie is about these rational people who went against the waves and shorted the markets and made huge money. I watched the movie 3 times to understand the complexity of the crash. 

HAPPY INVESTING.