There is a lot of blame go around, so dont think that I am exempting anyone from it. I'm just trying to find out directly where this whole mess started. I think I have. I am going to keep this short and simple. You all understand how the markets work so you will be able to follow along. We all know this all started with the subprime crisis. If you want to be uninformed, you can stop there, but we want to get to the bottom of this right? It turns out the amount of originated subprime loans increased dramatically starting around 2002-2003. Look at this table: <img src="http://www.irvinehousingblog.com/wp-content/uploads/2007/03/subprime-mortgage-portion-of-market.jpg"> Ok so we know we have a vast increase in subprime lending during that time, but why? Subprime loans have been around for a long time, why the sudden spike in subprime loans originated? Well as a lot of you know mortgage loans are just a product of the bond market. Collaterlized Mortgage Obligations (CMOs) to be more specific. The vast majority of loans made are bought by the secondary market (bond market). (Before you go thinking just Fannie Mae, remember fannie mae only hold around 10% of all the subprime market. As a broker I never funded anything to FNMA, as the guidelines for doing so were far stricter than non-conforming guidelines in the rest of the (0% of the market). As a broker the only reason for underwriting was to make sure the "lender" could sell the loan as soon as they funded it. The real lenders are people buying the bonds, that's where the money comes from. Of course different mortgages are packaged differently with separate risk profiles. Put simply, the riskier mortages back bonds paid more, while the less risky mortgage back bonds paid less. This is all just elementary stuff. So now t hat we know the mortgage market is merely a reflection of the bond market we have to ask, what caused a spike in the demand for risky subprime back mortgage bonds. They were always there, why did they suddenly increase, causing ultimately subprime lending to increase? This is the good part: the Credit Default Swap. As we know a CDS insures your principal when investing in a bond. Do you think its a coincidence that the CDS market grew 1000% (one thousand) between 2002 and 2007? The exact SAME time the subprime lending increased? Of course not. The demand for subprime-back bonds grew ( which of course means subprime loans originated grows) because bond holders could now, ostensibly, eliminate their risk. That is where the subprime mess started. CDSs in themselves though aren't bad. They serve a good purpose. But the smarter among you are wondering how on earth so much debt could be insured. The answer: it can't, but no one knows that. The reason no one knows is because CDSs are completely unregulated, and as a result there is no transparency in the market. The big financial companies were doing something called "netting". The value, or spread, of the CDS terms would of course fluctuate and they could take advantage and ostensibly insure everything. For example. Lets say you want to buy $10 million in risky subprime bonds,you want the nice return but you dont want the risk. You come to me and I insure you for lets say 2% of the total value per year. You're off the hook, but I am on the hook for the $10 million. You and I are in a CDS contract. I don't like all this risk though. Next week the market improves a bit and I go to another person, call them Bob, and say I want to insure $10 million worth of the same risky subprime bond. Bob says ok, i'll do it for 1.75% of total value per year. Perfect! Now I'm making 0.25% risk free, but I didn't tell you that. I have a CDS with bob. The market starts to head south a bit. Bob then is like shit, I'm on the hook for $10 million, he goes to you and says he I need to insure $10M in this risky subprime bond...you are insured so you say ok, I'll do it for 1.75% of total value, he agrees reluctantly because he's no longer making money, but hey at least he has 0 risk. Do you see the problem here? Maybe you do now, but it was impossible to see in the unregulated CDS market. Now what happens if I, you or Bob goes defaults? If you default, I default, bob defaults and so on down the line. This is exactly what the financial companies were doing. The numbers I used were pointless and arbitrary so please don't focus on those. The point is that because there is no regulation and no transparency no one has any idea if the company they just bought the"insurance" from even has enough money to pay it because they usually don't. This is what happens to a market when there is NO regulation. Great! everyone is insured! No on has any risk! Yeah, why do you think the Fed was so quick to bailout AIG? The CDs market is massive now, around $40 trillion. So basically deregulated CDSs lulled bond holders into a false sense of security, leading to a spike in demand for higher-yield subprime mortgage backed bonds, which of course led to the lenders on the ground funding more subprime loans. There's your crisis. Sorry guys, deregulation fucked us this time.