The chain of events is incredibly simple. Here it is -
- To promote the "ownership society", lending institutions were encouraged to provide mortgages to everyone who took the initiative to walk in the banks' doors.
- Since banks no longer hold and service mortgages, they had no reason to deny anyone credit. They received their fees only if they processed the paperwork so that's what they did.
- Banks passed the hot potato (bad credit risks) up the line to Fannie Mae, Freddie Mac, or anyone else who would take them.
- Many mortgages were bundled into "Mortgage-backed Securities" (MBS) and offered to the investing marketplace.
- These securities were given high financial safety ratings by the ratings agencies although they contained many troubled assets.
- Investors trusted investment banks and ratings agencies and bought the MBSs.
- Investment banks then created an insurance policy called a "Credit Default Swap" (CDS) which allowed a purchaser of the MBS to insure his return in case of default by paying a monthly premium.
- Since they did not call the "Swaps" insurance policies, they did not have to comply with insurance regulations for reserve requirements (money held to pay up in case of defaults).
- The investment banks who sold the MBSs also sold the CDSs, so they doubled-dipped into the investors pockets.
- The investment bankers established no reserves trusting that the MBSs would never default - at least they hoped they would not before they took their outrageous salaries and bonuses.
- On top of this, the massive deregulation of the financial industry (Commodity Futures Modernization Act of 2000) led by Republicans, such as Phil Gram, but also supported by many Democrats with their hands also in the lobbyists' pockets, allowed extensive gambling games to be placed on the whole mess. The plan was also blessed by Alan Greenspan and Larry Summers (a Fox who really loves the Henhouse).
- The gamble was this: two parties who had nothing to do with the basic MBS were able to select an MBS and place a side bet. Player A would sell Player B a CDS based on the Dallas Action MBS (DAMBS). This CDS has a time limit, perhaps a year. B pays a monthly premium to A for the year term. If DAMBS does not default in that year, B loses all his premiums and A wins. If DAMBS does default, A loses and B collects the value of DAMBS.
- With this scheme, the amount of bets placed on the underlying MBSs greatly exceeded the value of the MBSs themselves.
- Furthermore, the investment banks had absolutely insufficient funds to pay for any but a minimal number of defaults. [To a layman, that looks criminal.]
- When the bad credit risk homeowners began defaulting, often due to ARM loan interest rate increases, the dominoes began to fall, resulting in the investment bank meltdown we all witnessed.
Next I will blog on a simple way the bleeding could have been stopped - it could be to late now, but it's instructive to ponder why it wasn't done.
