I think you’re merging different activities which may have been done by the same bank, but would have taken place in different parts of the bank. And the cross-purpose activities would have only happened in mega-banks involved in retail and merchant banking, or merchant and investment banking.
The 2008 mortgage crisis was based on the fact that mortgages were cheap, often with little or no down payment, and the banks weren’t properly evaluating the ability of borrowers to pay back the debt. Mortgages are loaned out by retail banks – those involved in savings and lending. Basically, the worst retail banks were interested in collecting fees, not assembling proper mortgage portfolios. They wanted to issue the debt, and then package and resell it. Their profit came from the mortgage fees, not the difference between interest paid out to savers and interest collected from borrowers. To ensure their stream of fees, the banks would make the loans variable – cheap in the short-term, and moving to a higher interest rate after the short term. Rather than moving to the high interest rates, customers would take out a new loan paying the mortgage fees again. I presume this is the restriction on borrowers you’re referring to. The retail banks with this business structure were caught out if, when the merry-go-round ended and debt onselling stopped, they still had substantial unprofitable loans in their mortgage book.
Merchant banks were the banks who bought the mortgages, clumped them together, and then transformed them into real estate investment trusts (REITs), a form of bond with the mortgage loans acting as both collateral and the entities making payments to the bond investors. The merchant banks assessed the mortgages making up the REITs, published their assessment in the bond prospectuses, and submitted the assessments to rating agencies such as Moody’s. Many of these assessments were overly optimistic to the point of being fraudulent. Once issued, the REITs were sold, mainly to investment banks, although many would have been resold to institutional investors such as pension funds. Some merchant banks may also have issued credit default swaps, although I believe this was mainly done by specialised insurance groups, primarily AIG. The main intention of this instrument is as insurance for institutional investors. There’s nothing unethical about issuing both a bond and insurance for that bond. In fact, doing so for a bond you know is dodgy is counter-productive.
Investment banks seek to make a profit through investment in markets. They invest both their own money and that of customers, whether savers or investors. Within a banking group, merchant bankers and investment bankers generally aren’t supposed to talk to each other. Using the industry term, they should have a “Chinese wall” separating them. There should also be separations between some activities within an investment bank. Basically, someone trying to sell some instrument to make a profit shouldn’t be talking to someone in the same bank responsible for investing on behalf of customers. Bankers do get punished for violating Chinese walls, but they do have to be caught first. I’m sure there were investment banks buying credit default swaps, probably alongside the REITs and on behalf of their investors, but possibly also as speculation. However, I’m not aware of any banking group where the merchant bank was selling REITs, the investment bank was avoiding those REITs, but was buying credit default swaps for those REITs. I think that would be hugely frowned upon by the regulators. Selling bad bonds from the bank’s book to investors seems more likely, even if it’s supposed to be illegal. However, I don’t recall anyone being caught doing so. There was malfeasance happening at all three levels of banks that I’ve described. However, I don’t believe there was any top-to-bottom conspiracy.
Please note that this post, while long, is a vast simplification. I’m sure there are places where I’ve abridged too far.
No, the “borrowers” were corporations long or short bonds that the bank was betting against. In some cases, corporate customer B was given an incentive to help or hope toward a default by corporation A.