Robert Reich tries to explain.
Shorter version: Mortgage bankers and hedge fund managers saw a way to make
a few lots of easy bucks lending money to people who couldn’t afford the loans, then reselling the loans over and over again as investments. It’s part of the “everything should be for sale” mentality.
It’s called “securitization.” It means turning items that are not traditionally investments (that is, not stocks and bonds, but, rather, things like credit card debt and mortages) into things that look like investments (that is, turning them into “securities”–see definition number 6 here).
These things that have been “securitized,” though, have no intrinsic value (unlike a stock or a bond that, supposedly, is backed by the value of the products manufactured by the company issuing it). Those who buy those “securities” are investing in the debt of others and in the expectation that the debt will be paid off.
And, when persons suddenly can no longer afford to pay the debt, as when their mortgage rate suddenly goes up two or three percentage points, the “investors” are left holding a bag of useless paper. (Aside: When buying a house, 30-year fixed is your friend.)
Anyhoo, back to Robert Reich:
But what exactly happened to set this off? The story isnâ€™t simple, but Iâ€™ll try to state it as simply as I can. In recent years, with so much money sloshing around the global economy, American banks and other mortgage lenders found themselves with lots of cash. They thought they could make a tidy profit by pushing home loans â€“ not only on average Americans (whose eagerness to own a home or two thereby bid up housing prices) but also on poorer Americans who wanted to own a house but normally couldnâ€™t afford the interest on the loans. Oddly, private credit-rating agencies judged these â€œsub-primeâ€ loans to be relatively good risks. The loans were then sliced up and sold to other financial institutions where they were repackaged with other loans. Meanwhile, hedge funds created what can only be described as giant betting pools â€“ huge amalgamations of money from pension funds, university endowments, rich individuals, and corporations â€“ whose assumptions about risk were derived from the assumed low risks of the home loans (hence, the term, â€œderivativesâ€). Investors in these hedge funds had little or no understanding of what they were actually buying because hedge funds donâ€™t have to disclose much of anything.
It was not just a housing bubble but a financial house of cards that would tumble when central bankers tightened up on the global money supply in order to fight inflation, as they inevitably would, and when the home loans were thereby revealed to be far riskier than thought. Because the bad loans are so widely dispersed and because so much additional credit is connected to them through derivatives, a contagion of fear has spread through financial markets. The credibility of the whole financial system has become shaky. Large numbers of stocks and bonds appear riskier than before, which is why Wall Street is taking a beating.
In other words, the Fed has to bail out the speculators because weâ€™ll all suffer if it doesnâ€™t.
That doesnâ€™t mean, though, that the irresponsibilities now so clearly revealed in American financial markets should be excused or forgotten when the crisis ends. Wall Street has been living in an anything-goes world for too long. It has been widely â€“ and wrongly â€“ assumed that investors, creditors, and borrowers are smart enough to take care of themselves, especially if theyâ€™re big. Thatâ€™s wrong.
Poor people will lose their homes because they were sold loans they couldn’t afford with assurances from the salespersons that they could, indeed, afford those unaffordable loans, and no one, absolutely no one, who knowingly sold them those unaffordable loans will lose a home or see the inside of the pokey.
Mark my words.
Addendum, Later That Same Evening:
In the case of securitized credit card debt, the risk of default is negligible, because the default by a few of millions of credit card users has little or no effect on the value of the overall portfolio. But when you start looking at mortgage holders, whose debt is measured in hundreds of thousands of dollars, and see, suddenly, that hundreds or thousands of mortgage holders are falling into default, well, you can see what is happening . . . .
Securitization dot net, your free source for structured finance (whatever the hell that means) information.
My two or three regular readers have pointed out that the customers for many of the mortgages were adults who did not exercise due care. In many cases, that was the case. Nevertheless, I do think there were additional factors in play, so I’m putting my reaction to the comments up front, rather than burying them in the comments. Here’s what I originally wrote as a comment:
Unfortunately, as cases come to light, it’s apparent that many of the mortgage companies (Ameriquest comes to mind; remember, companies don’t sign consent decrees for nothing) exercised less than–er–full disclosure. Customers can’t ask questions that they don’t know to ask.
They were, in fact, selling the mortgage equivalent of toothpaste with antifreeze in it. Some of us (like Bill and Opie and, indeed, me) wouldn’t touch anything less that a fixed rate mortgage, ever. But we shouldn’t have to ask whether there is antifreeze in the toothpaste, either,
To call some of the mortgage sales practices “predatory” is to insult predators.
One of the damned shames of what’s going on right now is that Countrywide, which, by all reports, conducted itself with good business sense and treated customers fairly, is getting caught in the riptide.
Remember, too, that people do tend to be trusting (enron). They tend assume that, if a company (enron) is doing something, that something (enron) is not only legal, but, at some level, ethical (enron).
Until the roof caves in.