The sub-prime mess. How did it happen? Who made it possible?

I have a little experience in this from back when it all started rather innocently as a way to take bond investments that very few individuals or institutional investors wanted, and turn them into an investment that better fit the investment goals of a much larger audience. That was the birth of the Collateralized Mortgage Obligation (CMO).

Originally Banks and Savings and Loans issued 15 and 30 year mortgages that were pooled into bonds and guaranteed by the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). In order to have more money to lend to new borrowers, the originating Banks and S&Ls sold these newly created 15 yr and 30 year bonds to Wall St Bankers. Then Wall St expanded the appeal of these bonds by pooling them once again and redirected their cashflows, creating bonds that a lot of people found much more useful, bonds that had average payback expectations that were significantly different than the singular 15 and 30 year schedules of the original bonds that were used to collateralize the new bond issue (CMO).

In its simplest form, mortgage backed securities issued by GNMA, FNMA and FHLMC were nothing more than the inverse cashflows of the millions of individual mortgages borrowers like you and me took out which were then submitted to one of those quasi-governmental agencies to be insured under one of their guarantee programs. By getting these mortgages insured the mortgage companies and banks that made the original loans could then sell them to investors with a lower interest rate than the rate the borrower was paying the lender. That lower rate paid for the insurance and for the loans to be serviced by a service company which was sometimes a subsidiary of the original lender, sometimes not.

Since not every investor was/is looking for a bond investment that has a 15 or 30 year stated maturity, this limited the demand for these Federal Agency guaranteed mortgage bonds and hence the ability of lenders to make as many loans as they could. There were even fewer investors who needed or wanted an investment that paid the inverse of millions of mortgage payments combining principal and interest in every payment to eventually mature at a fully paid off loan with no principal value remaining.

Since there was a limit to where the lender could sell their now securitized mortgages, there was a limit to how many loans they could make to prospective home-owners because they had to hold onto the loans that they could not sell. That ate up the capital they had to make new loans, which limited the ability for home sales and new residential construction to take place.

As you can see, this was not a good thing for the economy and it placed a limit on the government's plan to use the quasi-agencies to provide liquidity to lenders and, hence it placed a limit on the American Dream, the ability for Americans to own and trade the homes they owed and move up! I think you can easily see how any plan to expand this capability would be a worthwhile endeavor all the way around and it was, right up to the point where it got out of hand.

I can't knock Wall St. too hard here because they have paid and still owe me a lot of money, and because they were responding, with all their wonderful creativity, to a real need. But then the nasty-greedy side of everything bad about capitalism began to spiral way out of control.

The CMOs they created started getting more and more convoluted and complex. They became so complex that it spawned an entire new financial information industry that made Michael Bloomberg a billionaire. This entire industry was originally dedicated to keeping up with how the cashflows from the different mortgage securities were being redirected in the many CMOs and their rapidly expanding structures and what that meant the value of each of the pieces or “tranches” might be under different future interest rate scenarios (some genius came up with using the French word for “pieces” to make them sound more sophisticated and more valuable). Well, ultimately they weren't more valuable; they were simply more complex, and their complexity obscured both their real value and their real risk to even the people who created them.

Now what made the sub-prime mess a true mess was that at some point ever more creative Wall Street bankers decided that they could keep the merry-go-round spinning and generate even more fee business for themselves by bypassing the limited collateral available for CMOs ( because not everyone could qualify for a loan under the credit underwriting guidelines of GNMA, FHLMC and FNMA) by finding a new source of collateral. Some smart banker realized that there were a whole bunch more people who still wanted loans to buy a home, whether they had good enough credit or not. The only thing standing in the way was that there was a limit to how much demand there was for low-quality (sub-prime) investments.

This is where Wall St Bankers truly shine. They really how to structure and market an investment so that an undesirable quality is minimized to the point of being deemed eliminated. In this case, they once again modeled and modeled the sub-prime collateral to see at what point over collateralization would allow an investor to come out whole, even if marginally more than the average number of historical defaults in the loans took place. Then they used their market-making ability to give these pieces of junk the appearance of liquidity and legitimacy and hence definable value to investors and the Collateralized Debt Obligation (CDO) was born.

As if that wasn't bad enough, several large Commercial Banks like Citicorp and others joined in and took the whole mess to an even higher degree by pooling huge numbers (trillions most likely) of these loans created in many cases by their own mortgage subsidiaries and moved them off their balance sheets by creating special purpose subsidiaries to buy them and issue short-term commercial paper to finance the purchase which moved them off the bank’s balance sheet and onto the books of the special purpose subsidiary. Then they got the Credit Rating Agencies to validate that the overcollateralization of the CDO, which was the only asset of the special purpose sub, was AAA credit quality. This allowed the special purpose sub to borrow the money to carry the CDO’s on their balance sheet with cheap short-term commercial paper. The interest spread between the higher yielding CDOs the sub owned and the short-term commercial paper used to finance them had the appearance of a pretty profitable business enterprise. Voila the Structured Investment Vehicle (SIV) was born and it was then sold to Banks and pensions and insurance companies and nations with too many dollars around the world.

With the seemingly endless liquidity provided by the creativity of Wall Street investment bankers and the greed of Commercial Banks playing out of their depth and desperate for yet more fee income and the desperate need of all these foreign entities awash in US Dollars from their sales of under priced goods and services to America, the whole thing grew to trillions and trillions of dollars invested in highly massaged and highly structured garbage. With all this liquidity and demand available to them, Mortgage bankers (and I use the term bankers very loosely here) were set loose to make every loan they could make to anyone who was breathing and could sign a closing document because it meant more fees for them and, since Wall St had seemingly structured away the risk of default, they didn't have to worry about any kinds of credit standards anymore.

The one thing 30 years in the investment industry at the institutional level can teach you is that no matter how much perfume you put on a pig, at the end of the day, it is still a pig.

No one truly understood or even today understands what can happen to overly complex investment products when something bad happens in the economy (read marginally greater than the averages used to structure the overcollateralization of these kinds of bonds) and/or too much light is shown upon the tenuous underpinnings of the ultimate source of payment. And remember all this was based on collateral (home loans) made to borrowers of questionable ability to pay and, in the worst cases of outright fraud, no ability to repay the loans they had made.

In short, when it dawned on everyone that "the Emperor has no clothes!", the whole business had grown so large that there simply wasn't enough room for everyone to squeeze through the door marked "EXIT" at the same time. And, as more and more people were willing to get out at any price, the market simply seized up and everyone was left holding on to what they had invested in to start out with "garbage".

Now you might think that is not such a bad outcome: greedy people got stuck with overly aggressive investments that they are going to have to hold on to and live with the ultimate payoff that will eventually come or not come. Now if that were individuals, things might just be bad for the individuals that bought them, but these were not the kind of investments you sell to mom and pop. You sell these to institutional investors, many of whom are publicly held companies or entities that have to report their financial activities to the public. In other words they have to be audited.

Auditors are funny about reporting things the way they are, not the way they were when you bought them. So, auditors (and regulators of entities like banks) are pretty insistent on these outfits that own this junk reporting their value to their shareholders and other interested parties.

This is where the #%$@ really hits the fan.

When these institutional investors begin writing down their losses in these CDOs and SIVs it impairs their capital and, in some cases, may cause some of them to become bankrupt. Oops!

If it is a going business like a bank, it might be able to get big investors to pump new capital into it, otherwise call your favorite bankruptcy lawyer. But here are two little complexities. One, nobody really knows what these things are worth or if enough of a write-down has taken place, and no one will know for years until the bonds have actually paid off or defaulted. Second, any banks that have taken these hits to capital are going to be very, very careful about how they lend in the future and expose what is left of their capital to their now heightened sense of credit risk. Less lending means economic slowdown. Economic slowdown means fewer jobs. Fewer jobs means diminished ability to pay your loans…

I could keep going, but I think you see where this is leading: BIG MESS. Now, before you become too maudlin about the prospects for the economy, understand that it is a BIG, BIG thing and it has a pretty good ability to recover from even big messes like this.

So, in the end, the question is: whose fault is it? Is it Wall St? Is it the Commercial Banks wanting to play like they are Wall St Bankers and greedy to grow their fee business and lever their capital even more? Is it the Mortgage bankers (I still can’t bring myself to call them capital “B” bankers) who took advantage of the immense pool of liquidity dangled in front of their eyes and the opportunity to earn even bigger commissions? Or was it the Regulators who let this whole thing go hog wild?

In the end there is no simple answer. “All of the above” would be my best guess. What is yours?