How could the banks lose so much money from subprime mortgage crisis in 2007/2008 when they could pass on the risks and are well aware of the risks?

The answer is to recognize the complexity of the housing market and the number of players involved in the securitization process. The guys making the loans in the first place were not the banks but the originators. Because they could transfer these risks by selling  bundles of loans onwards, they were lax about borrower solvency when they made the loans. Then come in the investment banks which would take these loan bundles and repackage into different products with specialised risk characteristics. For normal markets the assumptions which lead to these risk characteristics were quite fair. Thus assuming normal market conditions, the products which were labelled as lower risk were actually lower risk products. The banks would sell these products to pension funds and other participants who are mandated to restrict investments to low risk investments. Usually this would mean safe treasury issued instruments and perhaps very highly rated corporate bonds. When the economy is going great, all of this works very well. Now suppose the economy starts to deteriorate a little bit. From the point of view of the funds, the yields they are getting on their corporate bonds and the government bonds are drying up. They start hunting for more yield. They come upon these packaged mortgages with very attractive yields and safe ratings. Thus they create a huge demand for these instruments. The banks see that they can make a lot of money by providing for this demand. They start building inventories in these products to a. meet the demand as well as b. benefit from the appreciation in the prices of these products. The originators look at this hose of demand and start making more and more loans leading to further deterioration in lending standards. Of course the general population doesn't help at all with the propensity to avail of cheap loans. What is their motivation for taking out loans they well know they cant afford to pay back? Rising house prices enable them to roll their mortgages forward and they think they will never really have to pay back the mortgage amount. As the economy deteriorates further and housing prices stop rising , A. Borrowers start defaulting and B. Funds start seeing losses on their portfolios and stop buying these products. The banks are now stuck with huge inventories which they had built up because they were building inventories looking at the very peak of the demand. The market for these product collapses since there is no buyer anymore. In such conditions as banks are forced to mark to market (price these products at what they could sell for), the losses far exceed what it would have been if there was a liquid market. This leads to huge losses on balance sheets of almost every bank involved in the subprime packaging slicing and dicing businesss.

Everyone so far has left out the whole impact of insurance hedges by . Banks were trying to be reasonable about risks, so they bought these hedges () against what they knew were junk financial products. Unfortunately, it seems that AIG didn't know how bad these products were, and because there were no regulations, they didn't have any financial resources to back up these hedges. They thought that this was pure profit. But they were wrong.

You cannot get around the fact that banks did lose money despite their attempts to pass along much of the risk. Some factors include: Hot potatoes - They each always had some inventory waiting to be packaged and sold. Reluctance to take losses - Rather than take limited losses on inventory as the value went down, some held longer, awaiting recovery that never happened. Holding paper - They should have known better, but many invested in themselves. They thought holding a small share in a large number of mortgages was safer than 100% interest in a smaller number of loans. They thought they knew the market better than the general investing public but it turned out they were just wearing rose-colored glasses. Holding premium mortgages - Some skimmed the flow of mortgages coming in the door, keeping for their portfolio what they thought were the very best. Unfortunately eventually many of those went underwater too as the real estate market and job market went down. Take-backs - Some of the buyers came back against the originating bank saying that the loans sold to them failed to meet the conditions of sale.

The banks perceived the risk of mortgage securities as lower than they actually were. Prior to the housing market crash, banks were heavily leveraged on mortgages, eager to cash in on an ever rising real estate market (what we now know to be a bubble.)   With the shit hitting the fan in late 2008, banks suddenly needed to deleverage in order to make good on deposits by their customers. When a bank sells assets, the prices of those assets goes down. That selling process further cut the values of those securities, which were already difficult to value in the first place.

The market was flooded with over 20 million subprime loans.  Rubber stamp and pass on as fast as you can, but when the music stops you are nailed with the results. So the bank repossesses the house.  The bank is paying 0% on money it owes to the Treasury.  So they borrow more.  Then they sit and wait until the  housing market recovers and then they sell the properties. By the way, do you know that the ultimate destination for many of the loans was Fannie, Freddie and the Fed. Neat huh?

Because certain CEO's, traders (fixed income), credit rating agency chiefs, predatory mortgage lenders and the US Govt stood to profit so majorly. Hyman Minsky brilliantly conceptualised this in his Credit Cycle as the profit taking phase of a boom and bust scenario, which I cover extensively in my latest book. CEO of Lehman Bros Dick Fuld, for example, stated at Davos 2007 that they needed to get out of subprime as it wasnt looking good, but continued to gorge on subprime right up until Lehman's bankruptcy- even acquiring a subprime real estate firm along the way. Why? Fuld walked away with millions of dollars and had a significant self interest in riding this particular wave as far into shore as it would go. If you have a look at the story behind Magnetar's subprime trades, you'll see that they did nothing illegal but did help many major banks select assets for subprime CDO's (around 26) which they then shorted against, making a fortune. Some of the banks trading with Magnetar in those CDO's subsequently fell under investigation by the SEC. There were many other individuals such as John Devaney who thought that subprime was effectively a pile of junk but one of their most popular products so they just kept on pushing it as long as they could. Subprime related fraud had reached some ridiculous level - a 1,500% rise in mortgage based fraud or something similar - and the opportunities provides by securitisation of subprime were so extensive that it attracted a lot of fraudulent behaviours. If you look at the CEO's of all the major players on Wall St that imploded you will see that they walked away with millions in remuneration. The self interest was staggering. So what I am essentially saying is that a vast number of individual opportunists simply rode the wave to its extreme end point and walked away when it hit the point of absolute destruction with a profit. Also because - as behavioural finance eloquently shows - the markets are led by emotion, optimism, hubris, blind panic - and very little logic. To paraphrase Warren Buffett, Nothing sedates rationality like large amounts of money and that was certainly the case in the trading of subprime in the 2008 crisis. Its an unbelievably fascinating topic and I remember when I wrote the book, it was more of a challenge to work out what stories to leave out than it was to find great stories to include in the first place.

At least in the case of Citigroup, the firm did not realize that it failed to pass the risks to the clients. Long story: http://www.nytimes.com/2008/11/23/business/23citi.html?pagewanted=all&_r=0 Citigroup thought it was doing the same as its major competitors: buying a lot of risky debt; creating a structured note that was supposed to pass all the risk to the clients who bought the notes. With that in mind, Citigroup's CEO Chuck Prince announced that Citigroup had no subprime exposure. But it turned out that Citigroup's structured notes had a warranty-like clause, called "par put", that their competitors didn't. In plain English it said that the client can sell the note back to Citigroup for its face value (even though its market value is much less). So while the competitors' clients lost lots of money on their structured notes, Citigoup's clients were happy to exercise their options, forcing Citigroup to pay tens of billions of dollar for the structured notes that were trading maybe 30 cents or a dollar, and kept falling. As the result Citigroup became insolvent and would have closed down, had it not been bailed out by U.S. taxpayers.

Most banks were confident enough that a disaster won't strike, so they sold insurance on the subprime mortgage loans (so if the underlying assets went bad, the banks should pay the firms that purchased these insurance), that too at a very cheap rate. And when the disaster struck the value of the insurance was far greater than what these banks could pay, so they went bankrupt and had to be bailed by the government, but few couldn't be bailed out. Rest is explained in the video.

The simple answer is that the banks and insurance companies in question didn't understand the bets (a much more accurate term than investments) they were making.