The Financial Crisis Explained: Why Collapse Was Inevitable and How the System Changed Forever (Part Two)

Why the Crisis Was Already Baked

Wall Street was buried in subprime paper. Not a few firms. Not a corner of the market. The entire system.

By late summer 2007, the outcome was already determined. Subprime lending had come to a halt, credit quality was collapsing, and systemically important financial institutions owned massive amounts of the same toxic assets. The only remaining question was timing.

The crisis was not just a US event. It was global. The balance sheets of the largest financial institutions were tied together in a web of credit default swaps so complex that no one knew where risk began or ended. If one large firm failed, the entire system could go down with it.

From a moral standpoint, many firms deserved to fail. From a practical standpoint, allowing that to happen would have triggered a global depression.

That is why the crisis was inevitable.

Cause Three: Wall Street Owned the Problem

In part one, I explained how leverage exploded and how subprime mortgages became a massive, fragile asset class. The third cause completes the picture.

Systemically important financial institutions owned subprime securitizations in enormous size.

By 2006, subprime originations reached roughly 600 billion dollars per year. That produced a flood of securitizations and collateralized debt obligations. Eventually, there were not enough investors willing to absorb all that paper.

At that point, sanity should have prevailed. Underwriting standards should have tightened. Volume should have slowed.

That did not happen.

Everyone was paid on volume. No one was paid for prudence. So the securitization desks convinced their own firms to retain the excess paper on their balance sheets. After all, the securities were rated AAA. How bad could it be.

Those words destroyed the system.

Every major investment bank and many large commercial banks ended up owning massive amounts of subprime exposure. By the end of summer 2007, once investors stopped buying subprime securities, the crisis was locked in.

Cause Four: Derivatives and the Web of Destruction

The Great Financial Crisis had one feature that made it unique in history: derivatives, specifically credit default swaps.

Credit default swaps were invented to reduce risk for individual investors. Ironically, they increased risk for the system as a whole.

A CDS allows an investor to insure against default. That seems reasonable. The problem is that CDS contracts did not just exist between investors and banks. They existed primarily between financial institutions themselves.

Trillions of dollars of CDS contracts tied the balance sheets of banks, insurers, and dealers together. If one institution failed, it would trigger cascading losses elsewhere.

No one knew the true exposure. No one knew who owed what to whom. The system had become opaque and fragile.

This was the final ingredient. Too much leverage. A massive asset class that collapsed. Systemically important firms owning it. And derivatives binding everyone together.

That is why the crisis was not just likely. It was inevitable.

How the Crisis Unfolded

Once subprime securitizations became unsellable in 2007, the dominoes began to fall.

In late 2007, internal hedge fund losses at Morgan Stanley surfaced. Financial stocks wobbled but recovered.

In March 2008, Bear Stearns collapsed. It could not fund itself overnight. The government facilitated a sale to JPMorgan at two dollars per share, indemnifying JPMorgan against losses. The market breathed a sigh of relief.

But politically, that bailout mattered.

Treasury Secretary Hank Paulson promised that Bear Stearns would be the last Wall Street bailout. That promise would prove catastrophic.

In September 2008, Lehman Brothers failed. There was no buyer without government support, and Paulson refused to provide it. Lehman collapsed on September 14th.

Within days, the system seized up. AIG, which had sold roughly 80 billion dollars of credit default swaps on subprime exposure, teetered on the brink. Its failure would have detonated the global financial system.

The government intervened and effectively nationalized AIG.

At that moment, Paulson understood the truth. The system was on the edge of a global depression. He had no choice but to bail out Wall Street.

Justice was sacrificed to prevent catastrophe.

How the Crisis Finally Ended

The crisis dragged on into early 2009. Confidence was shattered.

The turning point came with the bank stress tests announced by the Obama administration. Banks were subjected to severe hypothetical scenarios and forced to raise capital if they failed.

The tests were harsh. Banks raised enormous amounts of equity. But the message was clear. After recapitalization, the system would survive.

That restored confidence. The crisis ended in the spring of 2009.

The Biggest Political Mistake After the Crisis

In my view, one of the greatest mistakes after the crisis was the lack of prosecutions of Wall Street executives.

The public saw a system that committed massive wrongdoing, received bailouts, and faced no personal accountability. Whether or not prosecutions were difficult, the perception was devastating.

It fueled populist movements and deepened distrust in institutions. That damage still reverberates today.

Why I Believe There Was Massive Fraud

The fraud was not subtle.

Wall Street firms bought subprime loans blind. They purchased large pools based on underwriting grids, then conducted due diligence only after the purchase.

Third-party firms reviewed a statistically significant sample, often 10 percent of the pool. By 2006, those samples showed that 10 to 40 percent of loans violated underwriting standards.

No firm ever ordered full due diligence on the remaining 90 percent.

Instead, they put back the worst loans from the sample and securitized the rest, selling them to investors while disclosing the risk in vague legal language.

In my opinion, this was the largest fraud in human history. The Financial Crisis Inquiry Commission documented it extensively and referred it to the Justice Department.

Nothing happened.

What Changed After the Crisis

The most important reform was Dodd-Frank.

For the first time, the Federal Reserve became the primary regulator of large banks. Capital and liquidity requirements increased dramatically. Banks were forced to delever, reduce risk, and improve risk management systems.

This made the system far safer. Today, I no longer worry about the systemic health of the US banking system.

But there were unintended consequences.

Silicon Valley Bank and the Limits of Regulation

The failure of Silicon Valley Bank in 2023 was not a replay of 2008.

It was not a capital problem. It was a liquidity problem combined with a uniquely concentrated deposit base.

Silicon Valley Bank surfed the yield curve aggressively during the zero-rate era, buying long-term bonds. When rates rose, massive unrealized losses emerged. At the same time, venture capital funding collapsed, forcing deposit withdrawals.

The bank was forced to sell bonds, crystallize losses, and failed.

This was not a systemic crisis. The system was never at risk. Venture capital was at risk.

The lesson was not that large banks needed more capital. It was that liquidity rules and deposit concentration matter.

The World We Live In Today

Seventeen years later, banks are far safer.

But two consequences stand out.

First, private credit has exploded as lending moved outside the regulated banking system.

Second, the big banks got bigger. Regulatory costs and technology investments favored scale. Deposit share concentrated further.

Looking ahead, bank fundamentals are solid. Credit quality is stable. M&A may increase. Regulation is becoming more pragmatic.

We will never return to a pre–Dodd-Frank world. But the system is evolving.

And that, ultimately, is the legacy of the financial crisis.

Until next time, this is Steve Eisman, and this has been The Real Eyesman Playbook. .
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This post is for informational purposes only and does not constitute investment advice. Please consult a licensed financial adviser before making investment decisions.