I read that it stemmed from a housing bubble in the US, but how did it affect countries like Latvia severely, or Estonia in terms of healthcare? Like, how did it become global?
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This is a really complicated question, and one that tends to get into flame wars pretty quickly based on your political affiliation. So I’m going to limit my answer very narrowly to the question you asked: how did the contagion *spread*? I won’t talk about how it started or what triggered it.
The short answer to how it spread, is that several decades ago, loans in general, and mortgages in particular, used to be held by banks. That is, if Wells Fargo lent you $100k to buy your house, they would hold that loan, and your payments would go directly to them to slowly pay it back. This meant that, if Wells Fargo wrote bad mortgages, they might go under, but it wouldn’t spread to other banks or other parts of the financial system.
In the 80s, this started changing, and in the 90s it got supercharged. Instead of holding loans, banks would package up like a thousand loans into a single Mortgage-Backed Security (MBS), slice it into “tranches” and sell the tranches to other investors. The idea was that the lower tranches would take the first loss on any foreclosures or other non-payments, in exchange for higher interest rates. So if you bought the highest tranches, in exchange for a lower interest rate, the bonds were safer because the lower tranches would take the first losses. So for example, the MBS might be structured that the first 10% of any loss would be taken by the lowest tranche, then the next 10% by the next tranche, etc. until you get to the highest tranche, where, of the 1000 loans in the MBS, 500 would have to foreclose before the highest tranche would take any loss.
Once these loans were packaged as MBS and sliced intro tranches, investors from all over the world could buy these securities. You didn’t even have to be in the mortgage business; Wells Fargo would continue “servicing” the loan (i.e. accepting your mortgage payments, sending you monthly statements, etc.) for a fee, and forward all the payments to the MBS investors. To an investor, they were just like a regular bond.
That’s how investors all over the world, from pension funds in Latvia, to health insurance companies in Estonia, got exposure to America’s housing market that they could never get before.
This all sounds great so far. Why did it all go down? Well, like I said, I won’t talk about what *started* the downfall. But one contributing factor was fraud: banks would stuff these MBS with loans they knew were risky, and ratings agencies like S&P, Moody’s, Fitch, etc. would give them the AAA stamp of approval. And then, when the mortgage market in America collapsed, all these so-called AAA bonds which were supposed to be as solid as a Treasury Bond began taking catastrophic losses. And that’s when investors all around the world got affected.
If you haven’t seen The Big Short, I highly, highly recommend it. It does a fantastic job explaining what happened, and it does it in a funny, engaging story. It’s not boring at all (unless you consider Margot Robbie explaining high finance while naked in a bubble bath boring! 🙂
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