Here's how it happened:
Big Fucking Bank (BFB for short) wants to package up mortgages into fancy packages and then sell them.
In order to do this, they divide the mortgages up into bundles of varying risk (called Collateralized Debt Obligations, or CDOs). The "junior" CDOs pay higher returns because they might not get paid back (if the underlying mortgages go sour). The next most "senior" get less return, but will get paid back before the junior. This proceeds up the line till you get to "super-senior" CDOs. These have low returns, but are guaranteed to be paid back.
There's always a risk that a given mortgage won't be paid back though, so BFB needs to keep a certain amount of money on hand, just in case, to pay off the senior bundles.
Or anyway, that's normally what happens. Instead, BFB bought insurance on the super-senior CDOs from a friendly company called AIG. These are called "credit default swaps," CDS for short. This insurance was expensive (so AIG got rich), but not as expensive as just leaving cash laying around as collateral on the CDOs.
Since this was super-senior debt, AIG's risk-management folks happily sold the insurance. Since the chance of having to pay a claim was incredibly low (theoretically), AIG only kept a little money on hand in case the claims went sour.
BFB's guys knew better though. They knew that AIG was deep into this business, so they had a lot of insurance policies on very similar CDOs. They also knew the nature of these super-senior bundles, which is such that they only way they could go sour (i.e. need the insurance) was if there was a broad, nationwide decline in property value. Unfortunately, exactly the same risk applied to all the super-senior CDOs, so if one failed (triggering a claim AIG would have to pay), they would all fail (triggering billions in claims that AIG had no way of paying). Thus not a single CDS had any chance of being paid in the event of a claim.
Nevertheless, the BFB guys had to take out the policies to "prove" that they had their obligations covered. Here's the real genius though. They knew that a broad drop in housing value would trigger all of these insurance policies at once, which would bankrupt AIG. So rather than buy insurance elsewhere (since no one else would sell such garbage) or find other ways to make money (the CDOs were too profitable), BFB hedged by taking massive "short" positions on AIG itself.
During the course of 2008, sure enough, house prices declined nationally. This had two impacts. First, BFB took a massive paper loss on their CDOs, because no one wanted to buy them anymore and the rules of accounting state that securities have to be "marked to market value." As a result, BFB didn't have to pay any taxes on the money it was still making from other activities. Second, AIG, as predicted, was unable to pay off all the suddenly-due CDS claims. So the government steps in and "bails out" AIG, which turns around and gives the money to BFB.
So the end result is that AIG is dead and BFB has the nice cash cushion they avoided in the beginning, along with the profits from short-selling AIG, which by the way they didn't need to pay taxes on because of the "loss" they took on the CDO. And BFB knew this all along.
Ladies and gentlemen, fuck me silly and call me Shirley, we the people just got taken to the cleaners, used and abused, and dare I say raped by a bunch of smart and slimy finance majors. God Bless America.
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