How Wall Street and the big banks killed The US housing market and America’s Golden Goose Along with it.

A synopsis on the evolution of the American mortgage business: the precursor to our current epic crisis.

The end of the run was beginning by 2005 when Wall Street created a new form of insurance for Mortgage Backed Securities. They created a system that was destined to implode while taking the taxpayer and the US economy with it.

The complexity of Wall Street derivatives is done by design. Those who hold the money have usurped power and wish to dictate that they keep both the money and the power. Their main objective is to make sure they profit first. What happens after that is of none of their concern.

The fancy terms, additions to Webster’s dictionary and the smoke screen that kills transparency are all meant to keep most Americans (and Congress for that matter) confused and bewildered. As long as people feel the dealings of Wall Street derivatives are over their heads, they are less likely to revolt against the self serving elite who have taken away the one Golden Goose the average person could enjoy.

The housing and real estate market have been one of the greatest drivers of the US economy since the great depression. It truly was the savior for the common man. There was a wonderful balance that made owning a home a privilege for the disciplined, planning American. You had to have a down payment with reasonable credit and your banker had to trust that you were good for your word. Loans were held by local banks more often and issues between mortgagee and mortgagor were easier to work out.

The government took steps to increase the ability of financing with a few government programs that would compensate the lender in event of a default. Certain criteria were used to allow people to take advantage of an FHA Loan so they could buy their first home. It was slightly easier to qualify but there were strict requirements as to maximum sales price and they property had to be owner occupied.

The VA Loan was similar but designed to help our veterans who would serve our country so well. This program was set up to get our veterans acclimated back into the community where they could re start their civilian life with a decent place to live, while investing for their future. It was a well deserved benefit for our service men.

There was no underhanded Wall Street dealings with most of these mortgages that later would be sold to corporations known as Government Service Agencies, or GSA. In reality Fannie Mae, Freddie Mack and the like were privately held companies but an implied notion that they were backed by the full faith and credit of the US Government become the wildly held view.

The common knowledge was that the government would step in to save these companies if they were in trouble because they were such a vital part of the mortgage business. They have been seen as the primer for the pump because many first time buyer loans were closed just because the banks knew they could sell them to the GSA as long as they followed the origination guide lines. In effect, this was the beginning of the true growth of housing in the country because banks no longer had to hold a particular type of loan that was lower balance and loaned with lower down payment and credit requirements. The bank would close the loan and ship it out freeing up ten times the amount of that loan in capital to be lent again. (Banks have been allowed to loan out 10 dollars for every dollar they have in deposits.)

It is easy to see how this could ramp up the origination of loans and the growth of the construction and housing industries. However, as the economy grew and Wall Street saw the benefit that could be had from the cash flowing long term mortgages an evolution was in the works.

More and more banks started to see the advantages of selling their loans to the private market. The banks would be free to collect more origination fees and often they would set up sister companies to collect additional income from servicing the loans that were no longer in their portfolio.

The loans would be packaged into pools and sold on the secondary market primarily to private investors who saw these vehicles, Mortgage Backed Securities, as a way to tap into the diligence and commitment of the mortgage paying citizen without having to manage anything. (Other than the income produced from the millions of mortgage payers of course)

It was a reasonable balance between portfolio loans which were solely their responsibility (the bank) in the event of default and the loans they sold. The system was set up in a way that held Wall Street in check due to the fact that there was little market for poorly rated packages of loans. The banks were careful to not underwrite an excessive amount of risky loans because they would likely have to keep them in their own portfolio.

If they were taking marginal borrowers for their portfolio it was usually at a much higher interest rate along with substantial down payment. The re sale of these loans was typically very difficult in the secondary market. This was a way that the system policed its own by giving banks no port for off loading high risk loans. So the so called risky loans came at a very high price for everyone involved. The borrower paid much higher interest rates and put much more money at risk in a larger down payment and the banks knew they would have to take the loss in the case of a default.

It all seems like a fairly stable system and it was until the creation of CREDIT DEFAULT SWAPS. This sounds like a big word of some importance but in its simplest form it similar to insurance. The key factor was that this insurance was to cover investors in the event of default of (the usually stable) mortgage backed securities that were packaged and sold on the open market.

This in and of itself seems reasonable. It probably even sounds like a good idea and something that could be effective in ways just like our home owner’s insurance. The investors paid a premium based on the inherent risk of the mortgage pools, most of which were AAA rated with a very good chance of performing well for many years. If the loans were of higher risk, the insurer would demand a higher premium.

Up to this point everything seems like just good smart business. But in 2005 a twist came into the market that set the course of US housing toward disaster.  The CDS was being sold to uninterested parties as from of “short” selling or hedging without any requirement for ownership or interest in the vehicle being insured. Simply put, it is like you buying insurance on your neighbor’s house so if his house burned to the ground, you would get paid the full value of his home, regardless of how much premium you had paid to that date.
Read Yves Smith debunking "The Big Short" here. 
This did two very critical things that are at the heart of our current crisis.

1. It overleveraged the insurers because they were selling far more insurance than they could collect in premiums, which also far exceeded the value of the insured asset. There was no way the insurers could pay claims made in the event of defaults, especially if the claims came very soon after the CDS was issued.

2. Now the investors who would never touch a risky pool of loans, or poorly rated loans, were lining up at the door to buy them. They no longer saw the risky loans as dangerous because they could also buy insurance on their investment. They were going to win whether the mortgages defaulted immediately or were held to term.

Now insert a little bit of free market capitalism and a huge market for sub prime or risky loans had been created. The demand that was never there in the past was now unable to be filled.

What were the mortgage brokers and lenders to do? There was a demand for more junk products so they went out and filled that demand with an unlimited supply of high risk loans.

I would guess partly in theory that the increase in real estate prices was inevitable and if there were defaults the insurance would be collected and the collateral (the home) would be taken back and sold at minimal loss that would come out of the huge profits made when they would collect full value from the insurers.

It was genius if you were a banker, broker or investor. They were going to win no matter what the outcome. It was recipe for disaster if you were a home owner or a real estate investor because much like a Ponzi scheme, the inflow of money would eventually stop before all the claimants were paid. The insurers started going under.
The Credit Default Swap Basis (Bloomberg Financial)


Let the Games begin

The biggest Loser  in all of this ? The taxpayer.