Friday, January 21, 2011

The Ten PM Tutorial v

Did poor people, living in homes they couldn’t afford, cause the 2008 crisis? Let’s look at the 2008 Global Financial Crisis, and discuss a few key terms for the unintiated.

In this issue of The Ten PM Tutorial, we are going to discuss: Mortgage Backed Securities, Collateralized Debt Obligations, Credit Default Swaps, and the explain the origins of the Global Financial Crisis.

Let’s start:

Mortgage Backed Securities (MBS): They are bonds made up of mortgages that have the same or very similar characteristics in terms of interest rates, risk, and period. The (theoretical) beauty of this sort of bond is that, as the name implies, it is backed by the property itself. Therefore, if the borrower goes into default, the idea was, the property can be foreclosed, sold at auction, and the money recovered. Hence—again, in theory—it was supposed to be a totally safe investment vehicle.

The kink in the system was, Mortgage Backed Securities depended on housing prices not falling. So long as they did not fall in price, the

Collateralized Debt Obligation (CDO): It is a bond made up of some item which is the collateral to the loan. Mortgage Backed Securities are a type of CDO.

Credit Default Swap (CDS): It is essentially an insurance contract, taken out on a bond. Suppose you, me, and Mary are trading bonds. Mary issues $1 million in bonds of her company, Mary Inc. You buy the bonds—but you’re not sure Mary will pay. So I sell you a CDS: If Mary fails to pay off her bond, I will pay it to you in her place.

Notice the name: “Credit Default Swap”. It is a swap (or insurance) for the case where a credit (or a bond) goes into default (or non-payment).

As you can see, this is really an insurance policy—but it is not regulated like insurance. In the case of fire, auto, and life insurance policies, government regulators all over the world make sure that the insurance companies that sell such policies have the money to pay off the claims.

But in the case of Credit Default Swaps, they were deliberately designed to fall in the cracks of regulation.

The Federal Reserve—under Chairman Alan Greenspan—should have regulated Credit Default Swaps. But he chose not to.

In 2008, a lot of mortgage loans had been given out to people who could not afford them. The reason was, mortgage providers wanted the fees: They would give a $600,000 mortgage to a Mexican gardener earning minimum wage, then turn around and sell the mortgage to investment banks. So the mortgage provider was no longer on the hook, if the Mexican gardener could no longer pay for the $600,000 mortgage.

The mortgage provider had collected his fee from the Mexican gardener, and collected his fee from the investment bank—so he didn’t care if the loan went into default, because when that happened, it wouldn’t be his problem.

So that’s why mortgage providers had such a huge incentive to give mortgages to people who should never have gotten mortgages: It wasn’t the Mexican gardener’s fault—it was the loan providers’ fault.

The investment bank took the Mexican gardener’s mortgage, and bundled it up into Mortgage Backed Securities—then sold them to customer, telling them that the bond was safe, because it was backed by the $600,000 house.

When the Mexican gardener (and everyone else) could no longer pay the mortgage, the house was foreclosed. Since several houses in a given market were all for sale for the same reason, housing prices in the neighborhood went down. Instead of $600,000, the house could only be sold for, say, $400,000—which was less than what was owed on the mortgage.

Hence, the houses were underwater: The loan was more than what they were worth on the market.

This effect started with the lowest class of mortgage loans—sub-prime mortgages—but it worked its way through all the mortgage loans in the U.S. housing market.

This started in 2006, but eventually reached the investment banks in 2008—they had bonds that were not worth what people thought they were. The losses were so big, that there was a panic.

That was—in essence—what happened in the fall of 2008: A classic bank panic, when everyone realized that the financial system was insolvent because of all these deals.

The banks were all bankrupt—and in 2008, people realized it.

After the panic, the regulators—that is, the Federal Reserve and the Treasury Department—did not do what they should have: They instead tried to prop up all the banks, and sweep the problems under a flood of money.

That is where we are today: The problems have been flooded with money—but the problems of insolvency have not gone away.


  1. So now where does it end? Tim G. has made it all too clear that he's prepared to threaten armageddon if the debt charade doesn't continue. Is QE3 a foregone conclusion? Or some kind of stealth continuation of QE2?

    The TEN PM Tutorial is great stuff btw, especially on bond questions, because I understood little about them.

  2. Back when the market crashed and woke me out of my blissful slumber, I came across this video which helped me to better understand exactly what led to the collapse. Figured I'd share it here in case anyone wanted a visual representation of what you just explained.

  3. Gonzalo, I think that in your post there are some "typos":

    The kink in the system was, Mortgage Backed Securities depended on housing prices not falling. So long as they did not fall in price, the...

    After the panic, the regulators—that is, the Federal Reserve and the Treasury Department—did not do what they should have: ...



  4. Please, you left out that Fannie May and Freddie Mac were buying a huge number of mortgages.
    Their mortgage buying criteria being that the worse the ability of the mortgagor to pay back the mortgage the better.
    This criteria was imposed by the Federal Government, starting during the Clinton administration.
    It didn't take long for mortgage brokers and bankers to figure out that they had a sucker that would buy all the junk mortgages that they could write.
    Clinton and liberals call this behavior "social justice".

  5. You defined Credit Default Swaps but didn't expand on their role in the GFC.

    I would like to know why those providing this "insurance" didn't pay up when the insured event (default) occurred - after all, they were the ones who had pocketed the premiums on this insurance while things were fine, not the taxpayers. Have any CDS's been claimed and paid as a result of MBS defaults?

  6. "It wasn’t the Mexican gardener’s fault—it was the loan providers’ fault."

    I would have left that out. While it may be argued that it's a matter of opinion, my opinion is that anyone who enters into an agreement that violates logic and common sense is at fault, Mexican gardner, evil mortgage provider, and greedy bankstas. (Shoulda let the teetering totter over the cliff and be done with all of it.)

    Thanks for taking the time with the tutorials - they are great.


  7. A couple of points you did not make.
    1)Congress forced banks and mortgage companies to make sub prime loans.
    2)Every subprime loan was fully insured. there should have been no loss to the owner of that paper. It was impossible to get a mortgage loan with less then 20% down without the insurance. What actually happened when the bubble burst was that the insurer defaulted on their contract. When the government bailed out banks and AIG they were trying to prevent the insurer from failing.

  8. GL, this article loses credibility when you don't mention the governments role in this chain of events. It should be acknowledged that institutions were forced to make these sub-prime loans at the threat of legislative penalties. It seems suspicious that you ignore such a drastic component of this crisis.

    I still enjoy the 10pm tutorial -keep pumping them out. Oh and the new rainbow background looks pretty gay man

  9. A new question from Kansas: If the US dollar is devalued formally, lets pick an easy number - 50%, what happens to our debt with the bank? Would my credit card debt with the Bank of American get cut by 50% too? would it stay the same?

    Historically, does debt get devalued when money is devalued at the bank?

  10. Gonzalo - not sure if you've seen it, but this PowerPoint presentation very succinctly sums up the entire Mortgage Mess:


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