Ice Berg Dead Ahead
The ice berg in this financial disaster turned out to be a new kind of mortgage, called a “subprime” mortgage, which was bundled into a new kind of debt instrument, called a CDO. Mortgages are simple and easy to understand. CDOs are the most complex financial instruments ever devised by humans – actually by math geniuses at MIT – and they are so hard to understand that it is safe to say that most of the people involved in buying and selling CDOs did not, in fact, understand what they were buying or selling. Worst of all, they did not understand how human beings might react when things went wrong.
During the period of extraordinarily easy money from 2003 through 2006, aggressive mortgage brokers found ways to obtain mortgage loans for borrowers who would not normally have qualified. These borrowers often had no down payment, and therefore no real personal investment in their homes. Even worse, many of them did not have consistent incomes or a consistent approach to paying their bills. As a result, their credit scores were terrible. Prior to 2003, these sorts of borrowers would have been shit out of luck if they wanted to buy a house. No one would have been willing to lend to them.
But because New York and London were awash with so much cash, and some sort of investment vehicle had to be found for this cash – the big banks could not afford to just sit on it – these “subprime” borrowers became grist for the financial mill. Mortgage companies sprang up all over the USA that could loan money to these people, then turn around and sell the resulting mortgages to others. This model of mortgage lending is called originate to distribute.
The End of Local Mortgage Lending
For a hundred years or more prior to 2003, mortgages had mostly been made by local banks to local people. Because the individuals were known in their communities, and because most banks and savings and loans invested only in a few communities they knew relatively well, banks didn’t need credit scores to qualify borrowers. They could appraise the property, take note of the down payment, and check the borrower’s employment and credit history just by asking around. It was a smaller, simpler world, and a safer world.
And there was less risk for the banks. Real estate prices in the U.S. rarely went up much, and almost never went down. People built their equities in their homes primarily by paying down their mortgages. Over time, they owed less, and their home values went up two or three percent a year. By the time they had paid off the house they were ready to retire and had a house that was worth perhaps twice what they had paid for it 30 years before. After factoring in the effects of inflation, it was worth about the same. This was the stable, predictable world that had generated most of the data that the whiz kids used to structure CDOs.
Subprime Entrepreneurs
After 2003, however, this old world was wiped out by aggressive new mortgage lenders like World Savings in San Antonio, Texas, and Countrywide Financial in Calabasas, California. These lenders would offered borrowers better deals and more flexible terms than they could obtain from more traditional mortgage lenders. They literally swiped millions of customers from the traditional banks, refinancing homeowners like crazy.
After originating the mortgage loans and collecting origination fees, these new lenders would turn around and immediately bundle groups of the mortgages into mortgage-backed securities (abbreviated MBSs) and sell these bundled mortgages to one of the big banks or investment banks in New York. By means of this procedure, loan bundles – some normal, some of the sketchy subprime variety – moved up the financial food chain from Countrywide and World Savings and other companies like them to the big money center banks and investment banks in New York.
There was nothing to worry about. Most of the risk had been offloaded by means of those brilliant new derivatives, those wonderful credit default swaps. If the sketchy mortgages started to go bad, AIG would have to step up and make good and pay off the CDSs. The big banks had covered their asses. Their investments were safe and sound, they believed.
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