Mortgage Originators Peddled ‘‘Liar Loans’’.

In the early 2000s, as housing investments increased in popularity, more and more

people got involved. Congress urged lenders Freddie Mac and Fannie Mae to expand

home ownership to lower-income Americans. Mortgage lenders began to rethink the old rules of financing home ownership. As recently as the late 1990s, potential home

owners not only had to provide solid proof of employment and income to qualify

for a mortgage, but they also had to make a cash down payment of between 5 and

20 percent of the estimated value of the home. But real estate was so hot and returns

on investment were growing so quickly that mortgage lenders decided to loosen those

‘‘old-fashioned’’ credit restrictions. In the early 2000s, the rules for obtaining a mortgage

became way less restrictive. Suddenly, because real estate values were rising so

quickly, borrowers didn’t have to put any money down on a house. They could borrow

the entire estimated worth of the house; this is known as 100-percent financing.

Also, borrowers no longer needed to provide proof of employment or income. These

were popularly called ‘‘no doc’’ (no documentation) or ‘‘liar loans’’ because banks

weren’t bothering to verify the ‘‘truth’’ of what borrowers were claiming on their

mortgage applications.

Banks Securitized the Poison and Spread It Around

At about the same time liar loans were becoming popular, another new practice was

introduced to mortgage markets. Investors in developing countries were looking to

the United States and its seemingly ‘‘safe’’ markets for investment opportunities.

Cash poured into the country from abroad—especially from countries like China

and Russia, which were awash in cash from manufacturing and oil respectively.

Wall Street bankers developed new products to provide investment vehicles for

this new cash. One new product involved the securitization of mortgages. (Note:

structured finance began in 1984, when a large number of GMAC auto receivables

were bundled into a single security by First Boston Corporation, now part of Credit

Suisse.) Here’s how it worked: Instead of your bank keeping your mortgage until it

matured, as had traditionally been the case, your bank would sell your mortgage—

usually to a larger bank that would then combine your mortgage with many others

(reducing the bank’s incentive to be sure you would pay it back). Then the bankers

sold these mortgage-backed securities to investors, which seemed like a great idea

at the time. Real estate was traditionally safe, and ‘‘slicing and dicing’’ mortgages

divided the risk into small pieces with different credit ratings and spread the risk

around. Of course, the reverse was also true, as the bankers learned to their horror.

This method of dividing mortgages into little pieces and spreading them around

could also spread the contagion of poor risk. However, starting in 2002 and for

several years thereafter, people couldn’t imagine housing values falling. So much

money poured into the system, and the demand for these mortgage-backed security

products was so great, that bankers demanded more and more mortgages from

mortgage originators. That situation encouraged the traditional barriers to getting a

home mortgage to fall even farther. These investment vehicles were also based

upon extremely complex mathematical formulas (and old numbers) that everyone

took on faith and few attempted to understand. It looks like more people should

have followed Warren Buffett’s sage advice not to invest in anything you don’t

comprehend! Add to that toxic mix the relatively new idea of credit-default swaps (CDS). These complex financial instruments were created to mitigate the risk financial

firms took when peddling products like securitized mortgages. CDS are insurance

contracts that protect the holder against an event of default on the part of a

debtor. One need not own the loan or debt instrument to own the protection, and

the amount of capital tied up in trading CDS is very small compared to trading

other debt instruments. That is a very significant part in the increase in popularity

at sell-side and buy-side trading desks. The big insurance company, AIG, was a

huge player in this market, and so were the large banks. The firms that were counterparties

to CDS never stepped back from the trading frenzy to imagine what

would happen if both the structured finance market and the real estate bubble burst

(as all bubbles eventually do) at the same time. Both underwriters and investors

would be left holding the bag when the music stopped playing—and the U.S. taxpayer

has had to bail out most of the financially-stressed firms to save the entire

financial system from collapse. Please note that all of this happened in a part of the

market that was virtually unregulated.