0 comment Saturday, June 28, 2014 | admin

After pouring over articles for months on end, my goal was to distill the information, explain in a few short paragraphs why this crisis has burgeoned. But alas, I do not have the talent; the beast has too many moving parts. So be forewarned. I've tried to simplify things, but this post is still very long and very wonky.

Wall Street wizards realized these hungry investors would snap up U.S. mortgages. So they came up with a plan to turn these mortgages into securities and sell them.

Each tranch is assigned a number of shares, sort of like stock. Investors can buy shares in any given tranch. The "shares" are called collateralized debt obligations, or CDOs.
As the borrowers make mortgage payments every month, the interest paid is doled out to the CDO investors in different amounts, depending on which tranch they are in.
The investors in the "good borrowers" tranch (the "super senior" tranch) get their interest paid first and the middle or "mezzanine" tranch guys get paid next. The bottom (bad borrowers) tranch investors get paid last, but they get the highest interest rate since they're in the riskiest position.

But there were not enough CDOs to go around. The returns were so good that investors wanted more. So the Wall Street boys called brokers like Countrywide and said, "Hey, down there. We need more mortgages so we can sell more CDOs. They're flying off the shelves." The brokers said, "We'd love to get you some more, but we're out of bodies. There's no one left who qualifies for a loan."

Why weren't investors worried the borrowers would default? It's true that even migrant workers were getting loans for million dollar houses. And no doubt, many of these CDOs could not be classified as good assets. But these CDOs were paying great returns and the default rate was low.
Default rates were low because house prices were continuing to climb. Never mind that prices were climbing at a rate never before seen in our country's history, and were unsustainable. As long as houses kept going up in value, the default rate was not a problem. If a borrower got into trouble, he could just sell his house for what he paid for it, or maybe more.

A CDS basically worked like this: A company like Bear or AIG would say, "don't worry, CDO investor. We are a strong and reputable company, rated Triple A by Moody's. If some borrowers default and you don't get all of your interest payment, we'll pay the difference. You'll never suffer a loss." In return, the CDO holder paid AIG (or Bear or whoever) an "insurance premium."
With a CDS insurance policy in place, ratings companies like Moody's could rate the top tranch, or "super senior" CDOs as triple A, or whatever rating was needed to put them in the "safe" category.

Inherent problem # 1: the CDS contracts were naked bets: The guys who wrote these "insurance" policies were so confident the mortgages wouldn't default that they didn't put enough (maybe any?) money aside to pay out loss claims if the mortgages went south.
When you buy fire insurance on your house, the insurance company is required by law to set a certain amount of your premium aside in reserves. So if you have a fire, the insurance company has the money to pay your claim. Same deal with auto insurance, homeowners insurance, all that stuff.

To make matters worse, there was no regulation of how many CDS contracts a company could write. As long as Moody's or Standard & Poor kept the "insuring" companies' ratings at an acceptable level, these guys could write all the CDS contracts they wanted to.

But the rating companies have an inherent conflict of interest. They only get paid if the Wall Street guys asking for the rating like what they say.
Suppose, for example, Bear has a big clump of mortgages it wants to securitize. It goes to Moody's and says, "Hey. We want you to rate our top tranch, our senior tranch, triple A." But the top tranch has some crappy loans in it.




Adjustable rate mortgages started re-setting at high interest rates and the already teetering borrowers could not make the higher payments. Boom. A rash of foreclosures in a neighborhood brings down all the houses in the neighborhood.
Why did the subprime defaults affect so many other parts of the economy? Why is it such a big deal? When the subprime mortgages started defaulting, a blood bath was born. The guys who wrote the credit default swap contracts couldn't pay the losses from the defaults. CDOs plunged in value. This caused a cascading effect.

Indeed, when Bear went down, the solvency of other investment banks was immediately questioned. No one knew if their counterparties (the guys who wrote the CDS contracts and were supposed to cover their losses) were any good.

Who owed who what? And who was good for it? No one knew. And still no one knows. Banks are curled up in the fetal position.


At first blush, it looks like Treasury Secretary Paulson keeps vacillating about about how to spend the money. First he said the government would buy these shitty CDOs from the Wall Street banks, but then he insisted certain banks take billions in cash instead.

Paulson: Mr. President, there's about to be a run on all the banks. We're talking a Mad Max scenario. Bush: Holy shit, Hank. What should we do? Paulson: give me a number, a REALLY big number. Some ginormous amount of money with no stipulations on it. The markets, the world must be confident we'll spend it however and wherever we need to, so we can stop the banks from falling like dominos. Bush: What's a big number, Hank? I didn't take geometry.Paulson: Ummm. 700 billion? That sounds pretty frigging big.Bush: Okay. And you'll use that money to buy the crappy CDOs, right?Paulson: Er, well, Mr. President, that's what we'll say we're doing. But what we'll actually do is throw money at banks. We can't buy the bad CDOs because then we'd have to value them. Once we did that, all the banks would have to revalue their own CDOs and restate their balance sheets. The revised balance sheets would show the banks are umm, insolvent. And then the runs would start. We're talking financial Armaggeddon. Better these CDOs go unvalued for as long as possible.Bush: Oh, right, Hank. I see what you mean. We can't have all of our banks in the red and trigger a run.And so it went, most likely.

Another shoe likely to drop? CDOs backed by commercial mortgages. Scores of commercial borrowers, the guys who build hotels, shopping malls, office buildings and the like, got the same exotic mortgages the subprime folks did: interest-only, ARM, or teaser-rate loans.



And I'm eating lots of crow, saying a lot of mea culpas. My husband was such an old fogey, I used to think, such a miser. Always on me to turn out the lights, turn up the air, turn down the heat, buy on the cheap. Lucky for me, he withstood my don't-worry-be-happy, let's-spend tendencies, and steadfastly refused to take out a big mortgage.

Labels: Subprime Primer