Picking up where I left off, in my bank, some of the loans that I have made are good, sound, loans. Some are, for whatever reasons, a bit of a stretch. Perhaps the people will lose their jobs when the factory shuts down or someone with a loan gets ill and loses their job for that reason, or perhaps someone simply misjudged the reliability of the loan recipient and it doesn't look like the bank is going to get their money back. In the traditional system, the good loans offset the bad ones and the trick was to make as few bad ones as possible. Now, however, we have other possibilities.
Let's assume that Mary, one of the bank's new employees, has a brilliant idea. Why not take some of the good loans and some of the bad loans and wrap them all up in one single bundle. You then get a rating agency to give it a AAA stamp-of-approval and then you simply sell the whole bundle to someone else for some set price, a price that is perhaps lower than the whole bundle if counted individually, but more than if the bad loans in there didn't get paid back.
You have two advantages: first, you are rid of part of your risk, and two, you have immediate cash in hand to turn around and loan out or invest and not have to wait until all the individual payments from all those individual loans come trickling in. And that's what they started to do, in various ways, with various colors and variations and who knows what all, but pushing these bundles of paper around – which are, it should be noted, a "derivative"; that is, an "investment" that derives from other forms of investment – becomes so popular and so many folks are getting used to speculation of all kinds that before long side markets show up where these things are bid upon, traded, exchanged, and who knows what else and everybody is just have a grand old time making up such derivatives and finding others who are willing to buy them or bid on them.
Again, it doesn't take a genius and just a moment's reflection reveals that the value of these bundles is pretty fictitious too. All of sudden there are bundles upon bundles that are bigger and bigger and all of them are "safe" because they've been rated safe, which increases my safe capital in my own institution, which means I can loan out more money and make more investments to grow and grow and grow and get richer, richer and richer. The only problem is that deep down beneath all those levels of paper and in spite of all the creative ways of accounting for these "instruments", as they were called, there's really nothing real at all. The "value" and the "worth" of any individual bundle was not the same. The bundles were once backed by whatever those bundles represented but once bundles were bundled and further bundled – the process can theoretically go on indefinitely – well, if you ask me, it all just starts getting absurd. One day someone is going to wake up, realize they are being sold a bill of goods and the house of cards could come tumbling down.
Welcome to the financial crisis of 2008.
Note: This series was originally published in slightly modified form on the Daily Kos.
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