The Federal Reserve Bank of New York

In December 2009, the global financial system was still in crisis. The market had bottomed a short nine months earlier, and the fear of a double-dip recession was palpable.

With the world still on edge, one high-ranking United Nations official came forward with a bold assertion: The world financial system was saved from collapse by $352 billion of illegal drug profits propping up several key international banks.

Antonio Maria Costa, then head of the U.N. Office on Drugs and Crime, told The Guardian at the time that this funding from drug cartels was "the only liquid investment capital" available to these struggling institutions. He did not name specific banks or specific transactions, but claimed to have seen evidence from intelligence agencies and government investigations. Costa even went so far as to imply that by propping up those key international institutions, the entire financial system was kept afloat.

Fact versus fantasy
Costa correctly pointed out that the crisis resulted from a liquidity freeze. While the financial system was overleveraged and undercapitalized, it wasn't until access to cash dried up that the system screeched to a halt. That is an underappreciated point today, when most analysts and reports in the media focus on new regulations that concentrated instead on capital levels.

This year, under the Dodd-Frank Act, banks are required to hold greater amounts of "high quality liquid assets" to meet a new, regulated, called the liquidity coverage ratio, or LCR. If you have listened to a bank's fourth-quarter conference call over the past few weeks, you have certainly heard many questions about the LCR and how these institutions are adapting to the new rules.

Costa didn't get everything right, though. There is an old saying that if your only tool is a hammer, every problem starts to look like a nail. In my opinion, after a career in drug and criminal policy, Costa might have fallen victim to this very circumstance. He told The Guardian:

In the second half of 2008, liquidity was the banking system's main problem and hence liquid capital became an important factor. ... Inter-bank loans were funded by money that originated from the drugs trade and other illegal activities. ... There were signs that some banks were rescued that way.

I respectfully disagree.

He might be correct that drug money was successfully laundered into the financial system during the crisis, perhaps even by a few desperate banks turning a blind eye to the illegal nature of the cash for the sake of survival. Per Costa's logic, those banks were able to then use the liquidity from the drug money to meet their short-term funding needs, and even issue commercial paper to other banks to support their day-to-day needs. That implies that this money saved the banking system, and that is going too far. 

With seven years of perspective, we can see what really saved the financial system
What really saved the financial system, in my view, was the unprecedented responses from central banks and governments around the world. In the chart below, notice how sharply the U.S. Federal Reserve's balance sheet expanded in mid-2008. From September to November of that year, the Fed increased its total assets by $1.3 trillion. That alone is 3.7 times more money than the $352 billion of drug money.

This jump was driven by a massive, coordinated stimulus program designed by the world's central banks to lower interest rates, jump-start spending, and backstop the financial system.

A 2011 the Government Accountability Office report found that by the end of 2008, the central bank had loaned more than $1 trillion to banks to unfreeze the liquidity crisis. In 2009, the U.S. government executed massive purchases of mortgage-backed securities -- many of which were considered toxic at the time -- to remove perceived risk from banks' balance sheets. That move successfully reopened the interbank lending banks rely on to fund day-to-day operations.

On top of all that stimulus, Congress was also hard at work. Federal Deposit Insurance Corporation insurance was expanded. Fannie Mae and Freddie Mac were explicitly backed by the government after falling into receivership. TARP, TALF, and a host of additional legislation backstopped individual banks and the system itself. The list goes on. 

Together, these programs totaled trillions of dollars in rescue funds and bailouts while also attendig to the psychology of the markets. By comparison, that $352 billion in drug money hardly makes a dent.

Foolish takeaway
Understanding what happened in 2008 and 2009 is critical for investors. In many ways, the systemic failings and the overwhelming response define how the financial markets work today. Banks have now deleveraged to much more reasonable levels, capital ratios are strong, and with the new LCR regulations, banks are better prepared for future shocks to liquidity. 

The causes and solutions of the crisis are much clearer today than they were in 2009. Costa was not wrong about the cause of the financial crisis or the mechanics of how the global system so quickly fell off the cliff. And his assertions about those few banks could very well be true, though we'll likely never know for sure.

Regardless whether Costa was right or wrong, this story is an opportunity for us to step back and examine our own biases, and how they affect our decision making. That means making sure that what you're hitting with your hammer is actually a nail, and not something else entirely.

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