The perfect storm

As we've already established in my last post, the financiers (da banks) had been given the government go-ahead to essentially do whatever they wanted, with the regulators asleep at the wheel.  Here's where the plot thickens:


For years prospective homebuyers went to a mortgage originator in their area for a loan, typically a small independent storefront operation or a bank or Savings and Loan.  The loan was made to a credit-worthy buyer, the loan company made a fee for their service rendered, and the loan was sold to Fannie Mae or Freddie Mac.  (These were government spin-off companies who had implied government backing.)  Fannie/Freddie would in turn pay back the local mortgage originator who would loan it again, make another fee, and sell it, too, to Fannie/Freddie, on and on. Fannie/Freddie would bundle these and sell them to investors world-wide who were anxious to own rock-solid investments in the can't-lose American housing market.


By the early 90's there arose a scheme by Fannie/Freddie and the politicians (of BOTH parties) to expand the number of people who owned a piece of "The American Dream". The financiers made money off the deal, and the politicians gained votes back home, claiming they were the ones who were bettering peoples lives.  Now given a regulatory green-light, the banks wanted in too.  (Fannie/Freddie had limits on the dollar value of the homes they could buy.  The banks didn't.)  The word went out to the loan originators to make more loans and the banks would buy them.  Before long all credit-worthy people who wanted a house had a house, so they lowered the qualifications for credit, income, etc to bring more buyers in. The loan originators pretty much looked the other way on everything because they made lots of up-front money to get loans signed and on to the banks.  They didn't care if the loans were no good because by the time the buyers defaulted they were way down the line and were somebody else's problem.


At the same time the bankers were hiring brilliant mathematicians to play with the numbers.  Instead of packaging and selling 100 homes to investors, why not slice each home loan into a thousand pieces, then sell each investor 1% of 10,000 houses from all over the country?  Investors love diversification.  It also made it easier to slip in some of those sub-prime loans (buyers with poorer quality credit).  Actually a lot of those sub-prime loans. Heck, why not bundle home loans with some commercial business loans, too.  More diversification...yea!  Everything was bundled with everything...the banks became very creative!  Foreign banks saw what was going on and jumped in, too.  Ireland, the UK, and Spain among others had large property bubbles also.  Things just took off.


But to make this work investors wanted assurance that these extremely difficult to understand CDO's (Collateralized Debt Obligations, the homes being the collateral) were as safe as they sounded.  The banks took each new bundle (called a tranche) they put together to the rating agencies, primarily Standard and Poors, Moody's, and Fitch, and had them look them over.  Problem was, this was a new concept and there was no historical data to refer to, so the raters made up new, and as it turned out flawed, mathematical formulas.  They forgot to include the possibility the value of homes might actually go down.  Oops!  And there was massive conflict of interest, too.  The ratings agencies were paid by the banks whose CDO's they were rating (standard practice), and there were lots of CDO's.  With millions of dollars in fees on the line, the raters pretty much said whatever the banks wanted them to say.  Virtually everything was rated "investment grade".


We now have irrefutable evidence that the bankers knew they were peddling investments destined to fail.  But as they were making hundreds of BILLIONS of dollars in fees for their banks and hundreds of millions of dollars in commissions for themselves, they weren't about to stop.  Greed rules!  Eventually homeowners began defaulting in droves, things began to fall apart, and investors stopped buying new CDO's.  Banks were caught holding hundreds of billions of dollars worth of flawed (fraudlent?) loans not yet sliced, diced, repackaged, and sold off.  Many were broke and were forced by the government almost at gunpoint to merge with other banks that were only slightly better off themselves.  To shore things up the government stepped in and "loaned" them hundreds of billions of taxpayer dollars to tide them over.  The mess is still being unwound today.


There was taxpayer outrage of course, so Congress feigned innocence and vowed to slap down the bad 'ol bankers (but of course they still take their calls and their campaign contributions).  Investigations were done, new laws have been written, and the bankers are working their lobbyists overtime right now to shoot the new laws full of loopholes.  Not a lot has actually changed.  Crazy speculation is still going on as evidenced by the failure of MF Global last year and JP Morgan Chase's loss of billions of dollars just last month.  We never seem to learn.


S


As always, factual constructive criticism would be appreciated. If I've erred on something please speak up.