The Goldman Sachs hearings missed the point - PART 2

So before I get on to subprime lending, I forgot to mention one additional structured financial product which is yet another complex combination of what I already talked about: the synthetic CDO. Recall that a CDO is a pool of pools of mortgage-backed securities. So an investor could buy slices (aka tranches) of a large pool of thousands of mortgages depending on what type of risk they wanted to take (keeping in mind that the higher the risk, the higher the return for the investor). A "synthetic" CDO is really just a combination of a CDO and a credit default swap. It's a bet that the slice of the CDO will (short) or will not (long) default.

And then yesterday, I found out that there is such a thing as a synthetic, synthetic CDO. (Yeah...you read that correctly). Again, these new products weren't built out of anything tangible...they were just bets. But it allowed more people to make more money off of a single mortgage transaction than ever before (no one had to go to the trouble of lending new money) and it gave investment banks the opportunity to collect more and more outrageously large fees.

Subprime lending: So now that this structured financial product wormhole-of-a-market had been created and CDOs, synthetic CDOs, and CDSs were flying off the shelves into the arms of salivating investors...they needed the gravy train to keep coming. But there are only so many houses in this country and so many responsible people that can afford to buy houses. Well, that pesky little fact didn't matter after the invention of the subprime loan. Traditionally, mortgages were long-term, fixed-rate loans that were labelled "prime" because the borrower met specific criteria like possessing good credit, a satisfactory income, and collateral (i.e., the property was in good enough shape so that the lender wouldn't get stuck with a lemon if the borrower defaulted). So that means "subprime" mortgages didn't have to meet these strict (and totally reasonable) standards. But since these new subprime loans were much riskier, the interest rates were set higher, which led to higher-yielding CDOs (exactly what the investors way down at the other end of the pipe were craving like crack cocaine).

I think everyone has heard stories about these loans..."no doc" and "stated income" loans were better known as "liar loans". The lenders didn't require anything to indicate that someone would be a reasonable and prudent borrower. And the "predatory" lenders would lure the unsuspecting borrower into the loan with arrangements of lower monthly payments in the first year (which then jumped up to prohibitively high levels thereafter) or the "pay option" where borrowers would pay less than the monthly interest (but the principal would go up). It was a total and complete sham! But it didn't matter to the lenders because they were making a killing off of the fees and then just sending it down the pipe to the gluttonous and completely uninformed investors. Those that did think about the quality of the loans would just convince themselves that the subprime loans were still good business because home prices would just continue to rise indefinitely. Here's another passage from 13 Bankers:

But that [risk of default] no longer mattered - at least not to the lenders or the investment banks - because the lending business model detached itself from the requirement that borrowers pay back their loans. Lenders made fees for originating loans; the higher the interest rate, the higher the fees. Then, when interest rates reset and borrowers became unable to make their monthly payments, lenders could earn more fees by refinancing them into new, even-higher-rate mortgages. As long as housing prices continued to rise, a single borrower could be good for multiple loans, each time increasing his debt.

This situation had disaster written all over it. It was a teetering house of cards. Again, 13 Bankers puts it better than I could:

The end result was a gigantic housing bubble propped up by a mountain of debt - debt that could not be repaid if housing prices started to fall, since many borrowers could not make their payments out of their ordinary income. Before the crisis hit, however, the mortgage lenders and Wall Street banks fed off a giant moneymaking machine in which mortgages were originated by mortgage brokers and passed along an assembly line through lenders, investment banks, and CDOs to investors, with each intermediate entity taking out fees along the way and no one thinking he bore any of the risk.

Finally, the bubble burst. Housing prices started falling. Huge mega-firms like Bear Stearns and Lehman Brothers (plus the government-backed Fannie Mae and Freddie Mac) collapsed into bankruptcy. Panic spread like wildfire into every nook and cranny of the banking system...even into places where no one would have ever suspected anything bad to happen. The government stepped in with a colossal bailout package for the firms still standing in order to keep the world's largest economy away from the edge of a deepening abyss. And now today...we are still trying to stay afloat after all of this with an unemployment rate still hovering above 10% and very few signs of a sustainable recovery anytime soon.
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Okay...so that's the ugly background. In Part 3, I'll get back to the recent Goldman Sachs hearings, which came about because of some fraud charges filed by the Securities and Exchange Commission (SEC) related to some synthetic CDOs that Goldman Sachs arranged.

[By the way, if you want another refresher on the crazy financial terms, try this glossary.]