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When bankers party, the world pays.If I have to put in one line what caused the 2008 financial crisis, I would say the investment bankers in America lead the world to a global economic crisis in 2008.In September 2008,the bankruptcy of the U.S. Investment bank Lehman Brothers and the collapse of the world’s largest insurance company, AIG, triggered a global crisis. Fears gripped markets overnight as stocks fell down instantaneously; it led to one of the biggest economic crises in the world which in turn affected the middle class and the lower class tremendously, as far as people committing suicides due to unemployment. The global recession cost the world tens of trillions of dollars and 30 million people were rendered unemployed.How and why did it happen?This crisis was not an accident. The financial sector, specifically the Wall Street being powerful, having lots of money and thus lobbies, step by step captured the political system of America. By the late 1990s, the financial sector had consolidated into a few gigantic firms, each of them so large that their failure could threaten the whole system. In 1998, Citicorp and Travelers merged to form Citigroup, the largest financial services company in the world. The merger violated the Glass-Steagall Act, a law passed after the Great Depression, preventing banks with consumer deposits from engaging in risky investment-banking activities. The Federal Reserve of America (Same as the RBI of India) gave them an exemption for a year, then they got the law passed. The law, namely Gramm-Leach-Bliley Act, overturned Glass-Steagall and cleared the way for future mergers.This act and the consequences of such deregulation can easily be explained by the metaphor of oil tankers. Oil tankers are very big, and therefore, you have to put in compartments to prevent the sloshing around of oil from capsizing the boat. And deregulation has led to the end of compartmentalization.THE FIRST TIME BOMB :Beginning in the 1990s, deregulation and advances in technology led to an explosion of complex financial products called derivatives. Thirty years ago, if you went to get a loan for a home, the person lending you the money expected you to pay him or her back. Now, in this old system, when a homeowner repaid their mortgage every month, the money went to their local lender. And since the mortgage took decades to repay, lenders were careful. In the new system, lenders sold mortgages to investment banks and these banks combined thousands of mortgages and loans,including car loans, student loans, and credit card debt, to create complex derivatives called “collateralized debt obligations” or CDOs. The investment banks then sold the CDOs to investors.Now when homeowners paid their mortgages, the money went to investors all over the world.Now that the lenders were secure, they didn’t care anymore about whether a borrower could repay, so they started making riskier loans. The investment banks paid rating agencies to evaluate the CDOs, and many of them were given a triple-A rating, which is the highest possible investment grade! The investment banks didn’t care either. The more CDOs they sold, the higher their profits.And the rating agencies, which were paid by the investment banks, had no liability if their ratings of CDOs proved wrong!In the early 2000s, there was a huge increase in the riskiest loans, called subprime. When thousands of subprime loans were combined to create CDOs, many of them still received triple-A ratings ! The subprime lending alone increased from 30 billion a year in funding to over 600 billion a year in 10 years. Goldman Sachs, Bear Stearns, Lehman Brothers,Merrill Lynch were all in on this. The greed of the top level investment bankers of American financial sector made them risk the public money while they were filling their pockets by leaps and bounds, whilst knowing how dangerous this could be!As a result of this, since anyone could get a mortgage, home purchases and housing prices skyrocketed. The result was the biggest financial bubble in history. Lehman Brothers was the top subprime lender, and their CEO, Richard Fuld, took home $485 million. On Wall Street, this housing and credit bubble was leading to hundreds of billions of dollars of profits. By 2006 about 40 percent of all profits of Standard&Poor’s 500 firms was coming from financial institutions. It wasn’t real profits. It was money created by the system and booked as income.During the bubble, investment banks were borrowing heavily to buy more loans and create more CDOs. The ratio between borrowed money and the banks’ own money was called leverage. The more the banks borrowed, the higher their leverage. In 2004, Henry Paulson, the CEO of Goldman Sachs, helped lobby the SEC (United States Security and Exchange Commission, a U.S government financial regulation agency) to relax limits on leverage, allowing the banks to sharply increase their borrowing. Investment banks were leveraging up to the level of 33-to-1 ! That means the borrowed money was 33 times the actual money in the bank.THE SECOND TIME BOMB :In the meanwhile, AIG (American International Group), the world’s largest insurance company, was selling huge quantities of derivatives called “credit default swaps” or CDS. For investors who owned CDOs, CDS worked like an insurance policy. An investor who purchased a CDS, paid AIG a quarterly premium. If the CDO went bad, AIG promised to pay the investor for their losses. But unlike regular insurance, other parties could also buy credit default swaps from AIG, in order to bet against CDOs they didn’t own !Let’s say I own a property, a house for example. I can only insure that house once. The CDS essentially enables anybody to actually insure that house. So 50 people might insure my house! So what happens is, if my house burns down, the number of losses in the system becomes proportionately larger! Since CDS were unregulated, AIG didn’t have to put aside any money to cover potential losses. Instead, AIG paid it’s employees huge cash bonuses as soon as contracts were signed! But if the CDOs later went bad, AIG would be on the hook!AIG’s Financial Products division in London issued $500 billion worth of CDS during the bubble, many of them for CDOs backed by subprime mortgages! The 400 employees at AIG Financial Products made $3.5 billion between 2000 and 2007. Joseph Cassano, the head of AIGFP, personally made $315 million.Through the Home Ownership and Equity Protection Act, the Federal Reserve board had broad authority to regulate the mortgage industry. But the Federal Reserve chairman Alan Greenspan refused to use it. Alan Greenspan said, “No, that’s regulation.I don’t believe in it.”WARNINGS :In 2005, Raghuram Rajan (The Governor of Reserve Bank of India), then the chief economist of the International Monetary Fund, delivered a paper at the Jackson Hole symposium,the most elite banking conference in the world. The audience were the central bankers of the world, ranging from Mr. Greenspan himself, Ben Bernanke (Chairman of Bush’s Council of Economic Advisers), Larry Summers (Former Chief economist of World bank and President of Harvard University) to Tim Geithner (President, Federal Reserve Bank and next United States Secretary of the Treasury).Rajan’s paper focused on incentive structures that generated huge cash bonuses based on short-term profits, but which imposed no penalties for later losses. Rajan argued that these incentives encouraged bankers to take risks that might eventually destroy their own firms or even the entire financial system. He particularly said : “You guys have claimed you’ve found a way to make more profits with less risk. I say you’ve found a way to make more profits with more risk.”Larry Summers opposed this paper. He basically thought that Rajan was criticizing the change in the financial world and Summers was worried about regulation, which would reverse this change.Then came Nouriel Roubini’s warnings in 2006, Allan Sloan’s articles in Fortune magazine and The Washington Post in 2007, and repeated warnings from the International Monetary Fund.You’re gonna make an extra $2 million a year, or $ 10 million a year, for putting your financial institution at risk. Someone else pays the bill, you don’t. Would you make that bet? Most people on Wall Street said, “Sure, I’d make that bet.”! It never was enough.These Wall Street people wanted to own five homes instead of one, expensive penthouses, private jets, and spent millions and millions of dollars in prostitution entertainment and drugs. All on the risk of destroying their own firms as well as the public money.THE CRISIS :Borrowers had borrowed, on average,99.3 percent of the price of the house. They have no money in the house. If anything goes wrong, they walk away from the mortgage! But Goldman Sachs took 8000 of these loans, and by the time the guys were done, two-thirds of the loans were rated triple-A ! They were rated as safe as government securities ! Goldman Sachs sold at least $3.1 billion worth of these toxic CDOs in the first half of 2006.By late 2006, Goldman had taken things a step further. It didn’t just sell toxic CDOs, it started betting against them at the same time it was telling customers that they were high-quality investments ! By purchasing “credit default swaps” (CDS) from AIG, Goldman could bet against CDOs it didn’t own and get paid when the CDOs failed. Goldman Sachs bought at least $22 billion of CDS from AIG. It was so much that Goldman realized that AIG itself might go bankrupt. So they spent $ 150 million insuring themselves against AIG’s potential collapse. Then in 2007, Goldman went even further. They started selling CDOsspecifically designed so that the more money their customers lost, the more money Goldman Sachs made.Rating agencies could have stopped the party and said: “Sorry, We’re going to tighten our standards,” and immediately cut off the funding to risky borrowers. Triple-A-rated CDOs mushroomed from just a handful to thousands and thousands. When testified, the agencies with their lawyers said : “When we say something is rated triple-A, that is merely our ‘opinion.’ You shouldn’t rely on it.”The market for CDOs collapsed, leaving investment banks holding hundreds of billions of dollars in loans, CDOs, and real estate they couldn’t sell.In March 2008, the investment bank Bear Stearns ran out of money and was acquired for $2 a share by JPMorgan Chase. The deal was backed by $30 billion in emergency guarantees from the Federal Reserve.On September 7th, 2008, Henry Paulson (Former CEO of Goldman Sachs and then U.S Secretary of Treasury) announced the federal takeover of Fannie Mae and Freddie Mac, giant lenders on the brink of collapse.Two days later, Lehman Brothers announced record losses of $3.2 billion, and it’s stock collapsed. By September 12th, Lehman Brothers had run out of cash and the entire investment-banking industry was sinking fast. That weekend, Henry Paulson and Timothy Geithner (President of the New York Federal Reserve) called an emergency meeting with the CEOs of the major banks in an effort to rescue Lehman. But Lehman wasn’t alone. Merrill Lynch was also on the brink of failure. And that Sunday, it was acquired by Bank of America.The only bank interested in buying Lehman was the British firm Barclays. But British regulators demanded a financial guarantee from the U.S. Paulson refused! As a result, Lehman Brothers went Bankrupt on September 15th, 2008.Lehman’s London office had to be closed immediately, and all transactions came to a halt. Lehman’s failure caused a collapse in the commercial paper market, which many companies depend on to pay for expenses such as payroll. It stopped business in its tracks.That same week, AIG owed $13 billion to holders of CDS and it didn’t have the money. If AIG had stopped, the whole system would have crashed down and the government knew it. On September 17th, AIG was taken over by the government. When AIG was bailed out, the owners of it’s CDS, the most prominent of which was Goldman Sachs, were paid $61 billion the next day. Eventually, the AIG bailout cost taxpayers of America over 150 billion dollars.In October 2008, the recession accelerated and spread globally as the world stock markets continued to fall amid fears. Unemployment in the United States and Europe rose to 10 percent. By December of 2008, General Motors and Chrysler were facing bankruptcy. And as U.S. consumers cut back on spending, Chinese manufacturers saw their sales plummet in abyss. Over 10 million migrant workers in China lost their jobs thus pulling other countries into the crisis. At the end of the day, the poorest, as always, paid the most.The corruption, greed and irresponsibility of Wall Street Investment bankers led the world to a global economic crisis as close as the Great Depression, while the lower and middle class paid for it.– Data excerpts from the documentary “Inside Job” on the 2008 crisis.