These derivatives, these securities, were created as brokers took bundles of mortgages and put them all together in one big pot. Some of these mortgages were what is called “insecure” and some were “secure”—rated triple AAA. Mixed together, they all became “securitized.”
All types of mortgages were securitized even though the risk was not of the same level. Good mortgages were mixed with bad mortgages. The rating agencies gave these mortgage-backed securities a very high rating because they didn’t really know what they were rating. These high-rated securities were bought by many pension funds and investors because of their higher rate of return, which, clearly, investors were looking for.
I understand. What I don’t understand is how these risky BBB
securities went into the same pot with AAA securities, got cooked up and retranched as AAA securities. How did these people, who supposedly knew better, do this so easily? The world is wondering, is this simply a matter of greed?
Oh, absolutely, it was a matter of greed! The point is that you create securities that are so complex and you base the valuations on models that only a few people can understand and determine what that valuation is. When you are in a time of euphoria, the market for these securities showed that they were good buys for investors. So seeking a very high rate of return, if you agree it is a good investment, you will invest in this without realizing there is no free lunch. These investors thought that there was a free lunch. This is what really happened and has had real repercussions, not only in the financial markets, but also in the real economy, because once you realize that your house is no longer valued as you assumed, you stop spending. And this impacts the real economy—we are seeing a decrease in spending, leading to a decrease in economic activity and an increase in the unemployment rate. That is how the recession began last December.
Each player in the chain must have known something was amiss. Real estate agents knowingly taking clients to look at homes they couldn’t afford. Potential homeowners thinking, “Wow, all I have to do is provide my name and income to the mortgage broker and I can be a homeowner.” Commission-driven mortgage brokers knowing they would not lose if a loan defaulted because by then it would have been bundled, resold, and someone else’s problem. Insatiable Wall Street traders with clients with lots of money in their hands looking for investments who told brokers to send them lots more of this extraordinarily lucrative product and regulations were loosened. Is this a correct picture?
This is exactly what happened. You are wondering why, right? Of course, with hindsight we say, “Who was that fool to believe that these kind of returns can be sustained?” Because, it was basically a scheme—the expectation was that houses would continue to increase in value. But as you know, nothing increases forever. In financial markets we call it the “Greater Fool Theory.” There is always another fool after you—until there is no other fool. And then the unraveling begins.
But you have to understand the sub-prime mortgages are only five percent of the total markets and are not the only cause of this calamity. It has to do with what we call the “slicing and dicing” of these mortgages—mixing them in with good mortgages. The problem is that investors believe that all the mortgage-backed securities are bad, because you cannot distinguish bad from good. Also we should not think that everyone who bought a house could not afford it. The traditional business of banks is to make loans and keep them on their books. In this case they did not keep them on their books. They sold them by way of securitization in the market. Some of them were given to Fannie Mae and Freddie Mac, who also got their fees and sold them in the market. People bought them thinking, “Well, Freddie Mac and Fannie Mae are semi-public companies, so the government is really behind them.” You know you can interpret these things in any way you want to justify a very high return.