Crisis? What Crisis?
The subprime mortgage crisis was a problem for all of us. Whether you were in Asia, Europe, Africa, one of the Americas or Australia, you most likely felt it. Rising costs in everyday things like gas, food and clothes were worldwide. And the subprime crisis was right in the middle of it.
CDOs were first created in 1987 by Drexel Burnham Lambert. If you remember the stock market crash of 1987, you might recall that afterwards there were several investigations into the marketing of “junk bonds”. DBL was famous for their part in that. So CDOs were not really all that new, but generally they weren’t used with mortgages. Researching at RiskGlossary.com, we find:
"CDOs are mostly about repackaging and transferring credit risk. While it is possible to issue a CDO backed entirely by high-quality bonds, the structure is more relevant for collateral comprised partially or entirely of marginal obligations."
Marginal obligations. That’s polite for bad loans. The way it would usually work is this: Lots of “marginal obligations” would get bundled together with a few reasonable ones and a very few highly rated ones. That bundle would be bundled with other bundles, created with a similar mix with the added dividend of several low quality bundles and at least one with a high rating. That mega bundle would get a high rating. Then the bundles would be “pooled”. Then these pools would be pooled. Then you take slices from bunches of these pools and and that makes a CDO.
If the CDO has at least one top rated, AAA pool slice, then the CDO has that rating. A quick slang primer: “Money good” is highly rated and everyone believes it’s guaranteed profit with no risk. “Toxic Waste”, well, you get the picture. What was happening was that there was alot of toxic waste being sold as money good, and at least some of the people knew it. But not the investors.
By now, which was around 2005, the investors weren’t just from overseas. The housing boom was so historic that it spawned television shows well into 2007. People who had never invested in anything felt fine investing in a house, or two. And those who didn’t join in the housing frenzy? If they held shares in money markets (usually via retirement funds) , their managers were happily buying up pieces of these CDOs.
Breakfast In America
By 2005 you could buy a house with no money down and resell it a year later for twice the price. For some reason everybody thought prices would only go up. And since anybody could get a loan, many did. By 2005 the average home cost 4 times the annual income of the average family. For most of our history, it’s been only 2 times the income.
But many who were able to get a loan were having trouble making the payments. Prices had skyrocketed, causing monthly mortgage payments to increase. It soon became obvious that just because someone could get a mortgage didn’t mean they could pay it off. The CDOs were supposed to spread the risk out so thin that no investor would be damaged if it performed badly. With so many CDOs filled with toxic waste, there were few that weren’t damaged, magnifying the risk.
People were getting loans, buying the house, moving in, and then defaulting on the first payment. It was a trend in 2006. The first to notice that anything was wrong were the biggest managers of all these CDOs. They noticed that even though the computer software showed acceptable risks, the actual performance was not what was projected by the computer models. Looking into the details, they found that far more defaults were occurring than the computer models predicted.
Crime Of The Century
As defaults piled up, property prices started declining. This was bad news for many homeowners. Many of them had already taken out ‘equity’ in their homes in the form of a home equity loan. In essence, they were making two house payments. With a basically flat economy, that can only last for so long. If you have a picture in your mind of some kind of lower class person just out to rip off the rest of us, you need to rethink. Most were hard working people trying to make a good life for their families.
By 2006 it was common to find people who had gotten mortgages they weren’t even looking for, sold to them by a guy who simply knocked on the door one day and offered them the American Dream. I personally know at least one person who, although he qualified for the best terms, was convinced by the local bank to take a much more expensive loan. Unethical standards were applied across the board, from the local level to the international level.
As the loan defaults continued, credit tightened up. The first to go was the NINA loan. With no notice at all to local mortgage companies, the larger banks and investment firms simply stopped buying them. Suddenly, billions of dollars which had been riding a fast moving gravy train were just stopped. Some banks went quietly of business. Some were bought, or “merged” with another bank to stay alive. (Sound familiar?)
Posted from my blog with SteemPress : http://nowthen.jonknight.us/blog/collateral-debt-obligations-toxic-waste/