TJABLONSKI

As an excercise for myself, I’d decided to try and explain parts of the financial crisis in English.  I know a lot of people have no idea what went down, so I figure I may as well put together some of the things I’ve picked up from my obsessive research on the subject.

The crux of the whole crisis is this: no one thought housing prices would ever decline.  As such, mortgages lenders gave very low interest rate, adjustible loans to people who couldn’t afford them long-term, with the thought that they’d sell them for even more than they paid before the rates reset to much higher levels after a few years.

The investment banking industry saw the potential in the white-hot real estate market and wanted in on the action.  The retail banks wanted to sell off the loans they made so they could have more money to issue even more loans.  This is like what would happen if my friend Kevin (borrower) owed me (retail bank) $10, and then I needed $10 to loan another friend (another borrower) money, so I had another friend John (investment bank) give me $10 and told Kevin he now owes John.  Add some profit (and subtract friendship) into that equation involving fees and other means of shaving off the top, and you can kind of see how this worked.

Instead of selling the debt to other banks, the mortgage originator banks packaged them up in bundles of thousands of mortgages, created a company that “owned” them, and then sold bonds (which are corporate loans that are traded on the open market) to investors.  Essentially, the investors were loaning a shell company (or a C.D.O.) money to buy loans from banks.  Since the loans paid interest that was higher than the principal of the loans, eventually all the investers would get their money back and more.

Ah but these were subprime loans… how would any investor every be assured that they would get their investment back, and make a profit?  The industry’s answer was to divide these bonds up into different classes.  At the top was a low risk pool; this pool would always get paid back first when people made mortgate payments, but since they took on the smallest amount of risk they didn’t earn much interest.  Each tier below this was lower down in the payback food chain, but since they had more risk, they had more reward if people paid back.  The lowest rung of this latter had the most risk, and therefore the gains could be enormous assuming people kept paying.  And they did pay, for a while..

Which leads to this madness, from Portfolio (as a side note, “shorting” something generally means betting that its value will go down):

Whatever rising anger Eisman felt was offset by the man’s genial disposition. Not only did he not mind that Eisman took a dim view of his C.D.O.’s; he saw it as a basis for friendship. “Then he said something that blew my mind,” Eisman tells me. “He says, ‘I love guys like you who short my market. Without you, I don’t have anything to buy.’ ”

That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans. But that’s when I realized they needed us to keep the machine running. I was like, This is allowed?”

All of this worked really well, and made a lot of people a lot of money when housing values were skyrocketing.  But when they started to fall, and when those adjustible rate mortgage rates reset and people couldn’t afford their payments, the whole thing came tumbling down like a house of cards.

Suddenly everyone was screwed.  Since huge investment banks had investments in these CDO’s, things started to unravel.  I’ll get to that next time.