Basically this collapse was not caused by sub-prime mortgages and the poor people who bought them.
The sub-prime market was only worth 600 billion dollars, I say only because past economic downturns the dot-com bubble, the Savings & Loan scandal, and the fall of Enron and WorldBank have all had impacts on the same scale as the subprime mortgage problem.
The fault for the Great Recession lies strictly on Wall Street, with a completely unregulated, off-the-books financial instrument invented more than a decade ago.
Wall Street found a way to create a financial tools called collateralized debt obligation, or CDO. Basically, he scrounged together about a thousand subprime mortgages, wrote a financial instrument that said, You buy this instrument, and provided that these mortgages aren’t defaulted on, we pay you dividends every year. So far, so good: you buy a widget, and as long as a bunch of people around the country pay their mortgage bills every month, you make money.
But every year, a few people stop paying on their mortgages, so people who purchased CDOs were going to take hits on their income. No one wants an investment that’s sure to do ‘middlingly-well’. So, in order to make the CDOs more attractive, the financial genius invented what’s called tranching. Basically, he split the instrument into three piles: the large, safe pile; the middle pile; and the small, risky pile
Investment rating people rated each individual tranche of CDO, and they gave the big, safe tranches a AAA rating – the best the market had to offer. That made the large, safe tranches look like something that everyone wanted a piece of: as safe as a government bond, but with a higher rate of return. No self-respecting conservative investor could turn it down – and almost none did.
Then came the housing bubble. Clinton and Bush might not have agreed on much, but they agreed that getting Americans into houses was good for the country. They both pushed for laws and policies that made it easy to get a mortgage even if you didn’t have the best of credit.
Subprime mortgages became more common, and with them, more CDOs were made – but the demand for CDOs went up even faster, because as the housing market accelerated, CDOs started making startling amounts of money.
This whole time, because CDOs were both profitable and confusing, the financial industry managed to convince the government to leave the CDO market completely unregulated
Enter financial instrument number two: the synthetic CDO. A synthetic CDO is like a real CDO, but it doesn’t actually have to have any mortgages attached to it. It’s completely fake in every way except that people actually just write up contracts betting on how many homeowners will pay their mortgage every month. Synthetic CDOs are literally just a form of gambling, and the financial market gambled BIG.
With no regulation, and a housing market that seemed to be on an unstoppable skyrocket, the market for synthetic CDOs exploded over the course of a couple of short years until it was worth almost two trillion dollars – more than three times the value of the real market it was based on.
Moreover, these synthetic CDOs were tranched up into various slices, sold, resold, and gambled upon by every single major financial entity in the country – and most across the world. If any one entity suddenly went belly-up and defaulted on all of the debts it owed to all of the companies that held various tranches of its CDOs, those other companies could easily go broke as well. In many cases the value of the CDOs held by a particular bank added up to more money than the bank actually owned.
That is where the idea of “too big to fail” came from – because if CitiGroup had gone under, the incredibly interwoven nature of CDO debt would have caused most, if not every, other major bank in the world to become bankrupt in a massive domino effect. Keep in mind that, while the banks would have failed, the geniuses that invented and sold CDOs and synthetic CDOs had long since pocketed hundreds of millions of dollars in ‘fees’ and would walk away scot-free.
Long story short: the invention of the CDO and the synthetic CDO created a hyper-leveraged market based almost solely on mortgages. The completely unregulated nature of the market meant that the housing bubble’s bubble-ness was multiplied a thousandfold. No one was around to warn people about what would happen when the bubble burst – and the financiers selling the CDOs certainly weren’t about to do it themselves!
The poor people who got lured into easy subprime-mortgage homes aren’t at fault. The credit rating organizations may have a little bit of fault. Realistically, however, the fault lies solely on two groups: the government overseers who decided to allow the CDO market to go unsupervised, and the wealthy financiers who created and sold CDOs to anyone who would buy
Greed and incompetence.
I would add another creation of Wall Street that greatly contributed to the financial crisis and that is Credit Default Swaps (CDS).
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p>Here’s why:
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p>1) As close to unregulated as you could get. There were companies that had multiples of CDS outstanding that far exceeded their actual debt. The only reason for buying and selling CDS on certain companies’ debt was speculation, extremely leveraged speculation.
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p>2) The regulators that should have been overseeing the CDS market did not understand the instruments that they were supposedly regulating.
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p>3) Many of the people buying and selling CDS had a minimal understanding of what they were doing and the risks that they were taking. But they saw companies like AIG making money and decided that they needed to be in the game. It also made for better cocktail party talk.
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p>4) The paperwork about who owned what and who awed who what in the CDS market was, to be kind, sorely lacking. This was clear to players in the market early on as contract forms continued to change and people were signing contracts that they did not understand. Often these contracts were in the guise of trade confirmations signed by clerks that obligated their company to financial liabilities that they did not comprehend. This became clear to the regulators when Lehman failed and there was a mad scramble to see exactly who owed money to Lehman and who was owed money by Lehman.
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p>5) It also allowed unscrupulous investors to use the CDS market to manipulate equity markets to earn profits there as well. Concentrated “attacks” on companies in the CDS market drove down their equity prices creating additional “panic” in the market.
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p>In my opinion this could have all been avoided if the government and the regulators would have treated CDS as insurance. By this I mean you would actually have to have an insurable interest to buy protection on a bond. An insurable interest in this case would mean actually owning the bonds or other debt issued by the company. No debt holdings no CDS for you. But this would have shrunk the market by multiples in the 10’s to 100’s and would have shut off the $$$$ spigot. So the Wall Street players lobbied for CDS not to be treated as insurance, money flowed, and we all got whacked.
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p>Well… way too many people who could not afford a specific mortgage, were given mortgages. This is, as you point out, not the fault of the ‘poor people’ but of the mortgage brokers, who were largely unregulated, and who were, by and large, guilty of widespread fraud.
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p>A synthetic is one whose underlying debt isn’t collateralized in the same way. If you unwind a CDO with mortgages underneath you will ultimately come to an actual ‘thing’ which you could then take possession of. The same holds true for a CDO of bonds… There is a piece of paper, at the unravelling that confers real ownership of something. A synthetic is more of a pure derivative: Some of the more popular synthetics, for example, were build on top of credit default swaps (CDS) which are complex agreements to pay insurance against extreme swings of interest rates. If you unwind a CDO that has a CDS underneath you come to an agreement between parties, not ownership. It’s not entirely accurate to call it, therefore, “fake in every way“. There is, after all, debt at the bottom of it… But it’s not a type of debt that is much regulated and never rated for safety and accuracy (and how could you do so? ) So it probably never should have been treated with much of the same mathematics as CDOs underlined by ownership debt.
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p>The entire idea behind CDO’s, of whatever stripe, is that people are constantly paying out debt and that this payout can be managed in a more or less automatic way, despite the fact that the underlying debt can often get messy. Probability tells us (we think) where the messiness, the bumps and wrinkles and potholes and cracks in the road, are most likely to be and allows us to think we understand the risk. Sometimes we do, but sometimes we do not.