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It seems that many people still do not understand the cause of the 2008 financial crisis and its consequences, because if they did, they would already be rioting in the streets. There are a few reasons for this, among which the total failure of the mainstream media to report it accurately and thoroughly, and the jargon used by the industry itself. Most attempts to explain the crisis have used financial jargon which serves only to confuse people and convince them that “the smart people are getting it done”, so they need not pay attention and can go back to work. However, it is really not as complicated as people often make it sound. I am not a Wall Street insider but I have researched the matter fairly extensively and I feel I have a working knowledge of how the crisis occurred. So to commemorate my 100th post, I have decided to attempt to explain it as clearly and plainly as possible.

The crisis could be said to originate with the Federal Reserve.

When people take out a loan or a mortgage, they are charged an interest rate. This is the cost of borrowing money. As the interest rate increases or decreases, it becomes more expensive or cheaper to borrow money. Banks also charge interest to other banks for lending, at lower rates than those on loans extended by banks to the general public. The Federal Reserve is the ultimate lender to banks. They set the federal funds rate, which is the interest rate at which the Fed loans to banks. The banks then charge higher rates to others, and this is essentially how banks make money.

Over the recent 10 years or so, the federal funds rates have been quite low on a historical scale (except for a brief “spike” from 2006-2008, but even this spike was low on a historical scale). Since 2009 it has been basically zero, between 0 and 0.25%. This means that money is cheap for banks to borrow.

When money is cheap, banks do risky things. Let us put this in a personal context. If I were to offer you money for 1% interest, would you use it for the same types of things you would if I loaned to you at 10% interest? In the former case, money is cheap, so you are likely to invest in something more risky as even if your investment fails, it would be cheap to maintain your debt payments. In the latter case, since the interest is high, you would think carefully about what you would invest in; you would likely invest in something that offers you a guaranteed return or profit, otherwise that 10% interest would really eat away at you.

This is essentially what banks did. They used the cheap money to make riskier investments. In discussing the crisis one often hears the terms sub prime lending. Sub prime lending means giving someone a loan who presents a higher credit risk at a higher interest rate; in other words, someone who probably did not deserve a mortgage because they were not as likely to pay it back. Banks would  charge these borrowers higher rates to make up for this increased risk. That is sub prime lending in a nutshell. Instead of giving creditworthy individuals loans at reasonable rates, banks lent to those who were risky, and charged them even higher rates (thus further reducing the possibility that they could pay back the loan or mortgage). Of course, many of these people were credit risks for a reason, and when they failed to pay back their mortgages, the banks were stuck with piles of noncollectable, worthless accounts on their balance sheets.

This brings us to another term: mortgage-backed securities. Knowing that they were stacked with worthless assets, the banks devised financial instruments to continue to make money. Banks combined actual, solid assets with bad, noncollectable mortgage-based assets into new financial instruments. These new instruments, which in extreme cases consisted 90% of noncollectable mortgages, were called mortgage-backed securities. The banks then bribed or influenced the ratings agencies (S&P, Fitch, Moody’s) to give these instruments AAA ratings – the same rating given to U.S. government bonds, which have been (up until recently) regarded the safest asset in the world with a guaranteed return. U.S. bonds only pay 1 or 2% interest precisely because they are regarded as safe.

Now that these “financial weapons of mass destruction” (as Max Keiser terms them) were given AAA ratings, the banks traded them freely with one another, all over the world. Investment banks in the U.S. traded with large and small banks throughout Europe, municipalities, state governments, pension fund managers, you name it. Everyone was buying these because they were rated a safe return. Bankers were making tons of money selling these, and the buyers were “guaranteed” a good return.

Yet at the same time that they were trading these, these same banks were buying credit default swaps (or CDS) against them. CDS are basically insurance policies. If Bank A buys a security from Bank B, Bank A can also buy a CDS on the security from Bank C, in case the security blows up (becomes worthless or uncollectable). Everyone remembers AIG and Lehman Brothers, the most famous firms in the financial collapse. These two sold credit default swaps by the truckload, and when people began to see that these securities were worthless, AIG and Lehman Brothers had to pay out on all these CDS, and quickly went bust. And that is basically how the crisis occurred.

Aside from the fraudulently high AAA credit ratings, doing this type of lending does not go against free market principles. If the banks take the risk and get away with it, they make money. But if they fail, they go bust. And that is what was prevented with the Troubled Asset Relief Program – or TARP, the bank bailouts.

These bailouts create what is called moral hazard. If a lending institution is not going to face any penalty for doing bad business, then what is to stop them from continuing to do so? They now have a guarantee from government that it will back them up if they fail. Nothing has been changed to halt these unscrupulous lending practices. In fact, it has been accelerating, because instead of raising the federal funds rate as they should have, thus raising the cost of money, the Fed has maintained it at its historical lows, furthering speculative lending. This was done to try and ease the pain of those with terrible debt burdens. But actually it does not solve the problem because the bad assets and cumbersome debt are still there, and just pushes an even worse crash further into the future.

This brings us to our final term – the derivative. A derivative is a financial instrument whose value is derived from a physical asset. Say for example that I have one barrel of oil valued at $100, and that you want to invest $100 in oil commodities, expecting the oil price to rise in the future. I borrow the money from you against my barrel of oil in a kind of contract. That contract is a derivative, which is essentially a type of “IOU”, as it is tied to a fixed asset that theoretically you could claim if I had to pay you off. If I then go and make another derivative contract with someone else on the same barrel of oil, there are now two contracts, or derivatives, that I have created. In other words, I have leveraged this one barrel of oil by 2 to 1 – two contracts for one barrel. If both people want to collect the barrel of oil at once, I go bankrupt. All of banking is predicated on the expectation that people won’t all want to cash in at once.

Banks all over the world are over-leveraged. In the recent collapse of MF Global, it was found that the firm was leveraged 40 to 1: that is, for every $1 in assets, they loaned out $40 worth of paper. This means that if their assets drop in value by over 2.5%, their balance sheets are worthless, and they go bankrupt. That is exactly what happened, and client accounts were destroyed.

All of the bailouts happening in the U.S. and Europe are designed to do one thing: keep the banks afloat. As long as the banks maintain operations, bank managers and CEOs can still collect their management fees and bonuses on client accounts. Meanwhile, peoples’ assets and pensions are being reduced to rubble.

Finally, I will end with this: it has been estimated that the total value of all derivatives in the world is $600 trillion, or 10 times greater than the GDP (gross domestic product) of the entire world.