The Simulation Argument

 2008 FINANCIAL CRISIS: A STORY

In the early 2000s, Alan Greenspan, the former Chairman of the Board of Governors of the Federal Reserve System sold the “American dream” by lowering interest rates which were never seen before. Everyone can buy a car, a big house thus would drive up consumer consumption and standard of living. Due to a lower barrier of entry, more people started living the American dream, until it came crashing in the midst of 2008. Many things went wrong, and it is hard to comprehend for someone without some esoteric financial concepts. So, let’s try to understand what lead to the global financial crisis, with a story.

Welcome to the town of Winesville

People of winesville, drink wine (it’s in the name) which gives them the strength to do their work. Yes, just like Popeye and his spinach drink. There is a winesville farm, which has the responsibility to prepare wine for the general public. The wine is made up of some key elements like Mortgagium, Student-Loancium, Car-Loancium (even periodic elements name does not make sense) etc. Mortgagium is the primary element, people are more relaxed and perceive it to be less risky to their health if they consume mortgagium backed wine (commonly called MBW). People pay the Winesville farm to mine these elements and prepare wine, which would indeed cheer up their lives.

The wine was served in a predetermined order, there were tables and wine was served sequentially from a bottle, starting from the first to the last table. The wine glasses at the front tables were small in size, as they were guaranteed that they would be the one to first receive wine, so low risk hence less wine. People at the back, had bigger glasses because they were uncertain whether they can avail to drink wine, thus higher risk and bigger glasses.

 

Some people did not want to drink their wine as they are doing fine now, so they planned along with others at the same table to re-sell the wine at Synthetic Winesville Farm. This way, they can earn some cash and can buy wine later. Synthetic Winesville Farm accumulated all wines and filled their bottle to serve their customers. Many other farms started to burgeon, strangely their names are Synthetic - Synthetic Winesville farm, Synthetic - Synthetic-Synthetic Winesville farm and keep on adding synthetic to the initial. So Winesville farm was prosperous, thus it trickled down to all synthetic farms, everyone was happy and were living the dream of their life.

But slowly rumour started to spread that, Winesville farm is mining junk mortgagium. The mortgagium miners were remiss and defaulted to mine quality mortgagium. Now, Winesville farm could not fill the entire wine bottle, and people could not get their share. These lead to the shortage of wine in the synthetic farms, who were waiting for the unconsumed wine from Winesville Farm. Also, non-MBW was risky for health. Some people could predict the fall of MBWs, so they started pouring money to an antidote. Due to increased health risks by consuming non-MBWs, people would fall sick and then they would require the antidote to heal, thus profiting the people who poured money to the manufacturing of the antidote. 

Many people planned for their health insurance cover from WIG (Winesville Insurance Group), in case Winesville fails to prepare MBW which would jeopardize their health. People paid a premium fee each month, to cover for their health insurance. WIG, unbeknownst to failing MBWs, started to issue insurance recklessly to everyone as they could profit from the premium if more people were on board with health insurance. But as the MBWs started to fail, many people lined up to get their health insurance, but the WIG could not cover all the people. So now it is absolute chaos in the Winesville town, people are falling ill, some lost their investment and people could see their dream getting shattered.

PUTTING IT ALL TOGETHER

Winesville farm refers to different banks like Goldman Sachs, Bear Sterns, JP Morgan etc. People deposited their savings in these banks and these were invested in securities (to make wine) which granted loans for mortgages (house loans), student loans and car loans (different elements present in the wine) etc. The interest paid by borrowers paid to return to the investors (filling the wine bottle). Mortgage loans are perceived to be less risky, because who defaults on their home loan (right?). So securities which combine mortgage loans along with other loans, are thought to be less risky, hence a risk-averse investment. These securities are called Mortgage-Backed Securities (MBS, just like MBW).

Coming to the sequentially arranged table analogy, the securities are sequentially stacked up like AAA, AA, BBB, BB and so on. AAA has less risk, as they are the first one to get the return from the interest payments, but they get less return (smaller wine glasses for people at the front). BBB has a relatively higher risk compared to AAA but gives more return (bigger wine glasses for people at the back). This stacked up arrangement is called a CDO or Collateralized debt obligation, or in which order you are obliged to pay the interest ( obliged to serve wine in an order). Now, the AAA securities were re-invested into another such stacked up arrangement called as Synthetic-CDOs (just like Synthetic Winesville farms). This process of investment and reinvestment continued until there were millions of these transactions. As people started to default on their home loans, the original CDO failed to fill and this led to a snowball effect as all the synthetic CDOs started to fail.

Short selling crude definition is betting against security (people profited from investing on an antidote, they bet against MBWs). Many short-sellers like Michael Burry and Mark Baum who predicted the fall of the housing market, had a short position on MBS and made millions when the market failed. American International Group (AIG, like WIG) insured for these risky investments by taking a premium fee. AIG unbeknownst to the failing housing market recklessly issued insurance just to anyone who can pay a premium fee. As the housing market came crashing so as AIG, as it could not cover for insurance, thus required a bailout by the American government with taxpayers money.

So this is the story of the 2008 financial crisis. With the collapse of the housing market, many people lost their homes, pension funds got wiped out, $700 billion dollar taxpayers money was used for the bailout of banks and insurance companies. So the taxpayers paid the price for the risky and unregulated investment carried out by the avaricious banks. The housing market crisis in the US snowballed into a global financial crisis. So who is to blame here, the avaricious banks, inadequacy for federal institutions to regulate the financial market or the people who chewed more than they can eat? I will leave it up to you.