Re: Question about "Inside Job"

[kunal naidu]

Hi all,

Here is a fine question posted by one of the FinQuest members about the movie, "Inside Job". I have answered his doubt below

Hey,
I watched "The Inside Job", the movie that you recommended. The movie talks about how Goldman Sachs and other investment banks made a lot of money by betting against the very securities that they sold by buying credit default swaps. So my question is that if this was the case, why did Lehmann Brothers go bankrupt and other banks start running out of liquidity? Shouldn't they have earned a lot of money once payers defaulted on their mortgages?
Also how exactly do these banks sell securities to their customers? Who are their customers? Are they simply the shareholders? If Goldman was making money(through cdf's), then their share price would have gone up and the investors also would have made money, right? So why the recession and the global meltdown?
Thanks.
Gaurav Reddy.

Hi Gaurav,

The way a Credit default swap works is that the Investment Bank, i.e. the "protection buyer" pays the "protection seller", in this case the American Insurance Group or AIG a monthly or quarterly premium. In return if any of the mortgage holders do not pay their mortageges, then they are said to have defaulted, and the AIG is supposed to make the required mortgage payment to the Investment Bank. The Investment Bank in turn, keeps some of it and distributes the rest as returns to the investors of the CDOs or Collateralised Debt Obligations, which was the final part of the securitization chain mentioned in the movie.

Now, as long as only some of the mortgage holders default, AIG has enough cash to fulfill its liabilities as the protection seller. What happened in 2008 that almost all the holders of mortgages defaulted simultaneously. As a result, the Investment Bank claimed a lot of compensation at once from AIG that depleted all the cash reserves of AIG and it went bankrupt. Once, AIG was out of cash, and the mortgage holders kept defaulting, the investment banks were forced to pay the investors of the CDOs with their own cash. Soon enough, the Investment Banks themselves ran out of cash, their stock prices tumbled and in this case Lehmann Brothers was the first to go bankrupt. 

Once the bank declares bankruptcy, the investors of the bank have lost their money forever. Once that happened, other investors stopped investing and held on to their cash. Now cash that is neither spent, nor invested is just paper that decreases in value over time. As a result, large companies that wanted to fund new projects were not able to get loans from banks since the banks themselves did not have money. Hence, production of goods and services slowed down. Profits declined. Once that happened, the companies were forced to cut costs to avoid going bankrupt themselves. And they did that by laying off workers. Hence unemployment started increasing. And this spread like wild fire across the world, leading to the recession of 2008.

Investment banks sell many complicated and researched products to investors. CODs are one of them. These CDOs might be part of a pension plan or a retirement plan or a monthly income plan. etc. If everything had worked out fine, then the investors of the CDOs would have made much higher returns than simply depositing their money with a bank in a fixed deposit.

Hope this answers your question. If anyone else has any other questions or doubts, feel free to mail me presonally, and I will answer that question to the best of my ability on this group.

Regards

Kunal Naidu