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By David Collison
Many of us have been personally impacted by the financial meltdown that was started by the collapse of the subprime mortgage industry. The real question is, is the current legislation the right answer?
Before you can answer that, you need to understand exactly what happened to the market. How did this happen? It's not a simple question. It took me weeks of reading and learning a whole new "bizspeak" language to figure it out.
WHERE IT STARTED
The roots of the problem are complicated. Part of it lies in the repeal of Glass-Steagall Act of 1933 which was designed in part to prevent problems in one financial sector from spilling over into others. Part lies in the belief that deregulation and reduced oversight are always good for America. And part lies in the 90s initiative that "everyone should own their own home". Those responsible span multiple Republican and Democratic administrations, and often had "bipartisan" support as they allowed this to develop.
The combination of all of these was a gradual loosening of lending standards, starting in the 90s and accellerating after that, with the result that people with lower credit scores than before were eligible for loans, called "SubPrime" because the credit scores were below optimal. The lenders offset some of the risk by charging higher interest rates for the riskier buyers.
But that wasn't enough. Many people couldn't afford the large payments that the higher rates would cause. So there was a gradual evolution of more and more "special" loans. Loans with low teaser rates, loans that had to be refinanced after 2 years, even interest-only loans.
Even still, the market probably wouldn't have imploded if the people MAKING the loans actually had to keep the loans on their own books. Who would make a risky loan if their own company would be left holding the default?
THE MORTAGE BOND
Then came a new idea. What if investment banks BOUGHT those mortgages from the lenders, and packaged them up as bonds, and then sold them to investors? You know, like they do with corporate debt?
It seems like a good idea. You increase the money available to make loans, which makes costs (interest rates) decrease, and even MORE people can afford their own home.
And the investment market gets a NEW way to invest money with a pretty guaranteed return on their investment. As the homeowners pay off the mortgages, a portion of payment gets paid back to the bondholders.
The problem was that mortgages were not like corporate bonds. Corporations almost never paid their bonds early. But homeowners can, usually by refinancing. And they usually do this when interest rates are low, so the bondholder gets his money back when he least wants it back.
To offset this risk, the Investment Banks created levels of each bond, called tranches. The bottom level paid the highest interest to the investor, but was the first to disappear if the loans were repaid/refinanced. The top level paid the lowest interest to the investor, but was the last to disappear if the loans were repaid/refinanced. (Notice NO ONE was thinking about defaults.)
Still ok, right? Well no, because now we have a problem. A BIG problem. See the loan originators now have practically ZERO long-term stake in the loans they are making. The money for the loans is coming from the Investment Banks, and going out the door to the borrowers. The Loan Originators make their commission and that's that. So lending EXPLODED. The use of "No Documentation" or "Liars" loans exploded. And many of these loans had a low 2 year "Teaser Rate" of 4-6% that increased to 11-12% or more after that.
So what did this do? Well it drove up house prices. If anyone can get a loan, then money becomes cheap and home values go up. This is what a lot of the home value appreciation was from. ARTIFICIAL DEMAND. People were taking out these loans, intending to flip the house or refinance when the value of the home increased.
The other side of this was the bonds. The top level of the bonds were rated AAA, which means they are as safe as Treasury Bills, practically no risk of losing your money. And that was pretty accurate...at first. The bottom level was rated BBB or lower. If 7% of the loans were repaid or refinanced, then the person holding that bottom slice of the bond would have his bond repaid and part of his potential return lost. (Again, notice no one is discussing DEFAULTS.)
The ratings agencies were rating these bonds based on general information: Average credit rating, geographical area, etc. But still it wasn't too bad. The only worrying thing here is that, like the Originators, the Investment Banks don't really KEEP the risk. They sell the bonds off and keep the commission. So they don't have a vested interest in whether the bonds are viable in the long-term.
THE CDO
Then came the voodoo. The Collateralized Debt Obligation (CDO).
See the problem was, the Investment Banks couldn't always find a buyer for those bottom levels of each bond. It was pretty crappy stuff. So they would do what? Why they would take that bottom slice from multiple bonds, package those together and VOILA create a new "Bond of Bond Slices".
This bond is made up of the worst risk slice of different bonds. So it should all be BBB, right? WRONG! The banks convinced the rating agencies that those slices were "diversified" since they came from different original bonds. And, like the plain bonds, the highest risk was the "new bottom slice" which would lose its value first. And the lowest risk was the "new top slice" which would lose its value last.
So the rating agencies rated the top slice of this CDO "Bond of Bond Slices" as AAA again, EVEN THOUGH IT WAS REALLY a BBB SLICE OF AN EXISTING BOND. The ratings agencies trusted the banks and failed the investors and failed us.
NOW the demand exploded. Because investors would EAT UP these AAA slices of CDOs. And the banks just repackaged until almost everything showed up as AAA slices SOMEWHERE.
So investors were demanding AAA Bonds, so the banks were happy to do so by repackaging any old garbage until it shone like silver. And the banks would buy any old garbage mortgage without looking too closely to do it, because the investors were buying the CDOs without looking closely at the mortages and so were the ratings agencies. So the Loan Originators would loan to ANYONE and even in some cases coach the borrowers on how to get a mortage loan approved that the borrower couldn't actually afford.
The CDS
Then it got worse. There is this thing called a Credit Default Swap. It was originally designed as an insurance policy against a loan defaulting. Say a fictitious bank called BANKY loaned $1Billion to a fictitious carmaker called BIGAUTO, they could buy an insurance policy from another company (let's call it BJH) that said if BIGAUTO defaulted on $250 Million of that loan, then BJH would pay the bank back the rest of the loan. In return, BANKY had to bay BJH premiums (just like any insurance) of say, $1M per year.
Where it gets crazy is that it got to where you could buy the CDS "insurance" even if you didn't own the risk. That is, BANKY could SELL the payout to someone else. Or even better, you could go to BJH and buy a CDS yourself EVEN THOUGH YOU HAD NOTHING TO DO WITH THE LOAN ITSELF. That was nothing but pure and simple gambling on whether another company would default on its debt, and paying a fee monthly or annually for the privilege.
So somewhere in all this insanity, some investors and banks began to think that maybe there was some risk here after all, so they (easily) convinced AIG to sell CDSs on these mortgage bonds and CDOs. AIG didn't really look too closely at the makeup of the securities. They TRUSTED THE RATINGS and they TRUSTED THE PROFIT THEY WOULD MAKE OFF THE PREMIUMS.
So they put themselves up to their eyeballs in hock, selling "insurance" to people who didn't even own the bonds. Insurance that would pay out if the bonds started defaulting. But that couldn't happen right?
The Endgame
Of course it could. It was foregone. It was unavoidable. The entire house of cards was built on lies and ignorance, driving what was supposed to be a free market way over its banks until the dam burst. First the defaults started as the teaser rates ran out. Then the bonds started losing their value and the CDOs failed in droves. And the calls for cashing in those CDSs started.
Who lost here?
AIG right? Well wrong. AIG got significant bailout money to "save the financial system". But AIG was not the real problem here. AIG was propped up so that the investors who bet the market would fail wouldn't lose their winnings. AIG got TAXPAYER DOLLARS to pay of the winners of the bet folks.
The banks right? Well some banks went out of business or were bought out. This is true. Many of these received bailout funds too though. But really, the people working there who got their $millions in commissions still have those commissions. Many of the traders who sold this garbage are sitting on a beach in the tropics, sipping drinks. They certainly didn't lose.
The lenders right? No again. Sure many went out of business, but the PEOPLE who worked there, the ones earning commissions by loaning to people who couldn't afford the loans, they have those commissions safely tucked into bank accounts.
There are two groups who really lost here.
The first are the institutional investors who could legally only invest in AAA rated securities, who got scammed into buying garbage. These are the investment funds of charities, municipalities, non-profits, and retirement groups. They lost $Billions. And no one offered to pay THEM back. No bailout funds went to them.
The second are the citizens who have lost their livelihoods because of the crash or are upside down on their mortgage because these modern-day pirates drove up housing prices by gaming the system. There is no bailout for us. There is no program to give us back our jobs so we can make our house payments.
Imagine. What if the solution had been to halt new crappy lending and fix the toxic loans that were out there SO THAT THE BONDS WOULD NOT FAIL. Who would have won? The investors, the citizen homeowners, and you folks who would have kept your jobs. Who would have lost? The investors that bought CDSs and the banks that were making money off the transactions.
So the Republicans and Democrats both bailed out AIG, the banks, and the people who wanted their CDS winnings, but they didn't bail out the people who really got hurt where it counts. And the Republicans want to cut off extending Social Security benefits to those who lost their jobs as a result.
Ask yourself the question, whose side are they on? The answer is pretty obvious...
David Collison has been a Reform Party member since 2001 and is currently the Chairman of the Reform Party National Committee. He is an engineer by education and a training consultant by trade.
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