Here, in a nut, is the unholy chain of events that nearly destroyed the global economy:
Investment banks began to combine large packages of loans into bundles called “Collateralized Debt Obligations,” or CDOs, which were then sold to investors. Because the CDOs consisted of many loans, the risk was diluted. Some of the loans in a particular CDO might go bad, so the thinking went, but most of them would continue to pay regular, steady returns. As the demand for more and more CDOs grew, lending rules were relaxed to the point where the banks were no longer obliged to verify borrowers’ income or even their employment status, hence the rise of the Sub-prime loan. With the onset of the subprime market, investment firms like Lehman Brothers, Goldman Sachs and AIG began offering Credit Default Swaps, a new instrument which amounted to an insurance policy offered against the CDOs.
When demand for CDOs even outpaced the volume in the subprime lending market, investment banks began bundling Credit Default Swaps into CDOs and offering them as a new financial instrument. That's where things started to get really dicey. Once the real estate bubble burst – as, inevitably, it was bound to do -- all those Subprime loans went belly-up, then the CDOs went bust, and then the Credit Default Swaps came due. It was at that point that the CDOs crafted from bundled Credit Default Swaps turned radioactive, and the whole house of cards came tumbling down.
We have yet to recover.
Investment banks began to combine large packages of loans into bundles called “Collateralized Debt Obligations,” or CDOs, which were then sold to investors. Because the CDOs consisted of many loans, the risk was diluted. Some of the loans in a particular CDO might go bad, so the thinking went, but most of them would continue to pay regular, steady returns. As the demand for more and more CDOs grew, lending rules were relaxed to the point where the banks were no longer obliged to verify borrowers’ income or even their employment status, hence the rise of the Sub-prime loan. With the onset of the subprime market, investment firms like Lehman Brothers, Goldman Sachs and AIG began offering Credit Default Swaps, a new instrument which amounted to an insurance policy offered against the CDOs.
When demand for CDOs even outpaced the volume in the subprime lending market, investment banks began bundling Credit Default Swaps into CDOs and offering them as a new financial instrument. That's where things started to get really dicey. Once the real estate bubble burst – as, inevitably, it was bound to do -- all those Subprime loans went belly-up, then the CDOs went bust, and then the Credit Default Swaps came due. It was at that point that the CDOs crafted from bundled Credit Default Swaps turned radioactive, and the whole house of cards came tumbling down.
We have yet to recover.
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