More Americans should own their own homes, for reasons that are economic and tangible, and reasons that are emotional and intangible, but go to the heart of what it means to harbor, to nourish, to expand the American Dream.
—William Jefferson Clinton, November 1994
So begins the recently released book, Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon, by Gretchen Morgenson and Joshua Rosner. Morgenson is a business reporter and columnist for the New York Times, and Rosner is a housing and mortgage finance consultant.
I have just finished reading it, and as bad as I thought the 2008 financial markets meltdown was, it was worse. The book depicts a tale of corruption, vote buying, governmental intimidation, and complicity between key government leaders, Wall Street firms, the executives of Fannie Mae and Freddie Mac, and regulators who tag-teamed to hornswoggle the American taxpayer – apparently legally because none of them has been charged with a wrong-doing.
How did it happen? I will devote this and my next blog to answering that question.
Two years into his first term, Clinton spoke to a fawning audience at the National Association of Realtors' annual meeting in Washington, D.C. and announced a new program, National Partners in Homeownership, a private-public collaboration whose goal would be to raise home ownership from its mid-1990s level of 64% to a hoped-for 70% in 2000.
Never before had regulators teamed up with those they were regulating, as would be necessary in the Clinton program. Unanticipated was the impact of loosening the home-buying rules to accomplish program’s goal – reduced down payments, historically the way to assure home buyers had substantial skin in the game; risky loan-to-value ratios; less due diligence on the borrower’s creditworthiness; and relaxation of the applicant’s debt-to-income ratios, which disqualified some aspiring homeowners and prevented others from taking on more home than they could afford.
Unchallenged and unexamined was the economic value of increasing the national home ownership six points, destabilizing the natural growth in housing demand and production, using government subsidies (which in the end are taxpayer financed) to create an inevitable bubble while inducing people to take on a strange new obligation for them – a home mortgage – for which they lacked the means and economic discipline to repay or sophistication to understand. Just as a college education is not for everyone, neither is home ownership. Improving access isn’t the problem.
Yet, the foregone conclusion of the Clinton program was that access problems had indeed locked out otherwise deserving people from home ownership, and that was to be the focus of Fannie Mae and Freddie Mac – two quasi-governmental institutions that facilitated the country’s home ownership.
Fannie Mae is a relic of the Roosevelt New Deal. The Federal National Mortgage Association (FNMA cum Fannie Mae) was created in 1938 during the height of the Great Depression. Originally its purpose was to provide local banks with federal money to finance home mortgages in an attempt to raise levels of home ownership and the production affordable housing. Fannie Mae provided loan originators a secondary market to sell FHA-approved mortgages. In 1968, with the cost of the Viet Nam war increasing the national debt, Lyndon Johnson wanted to get Fannie Mae off of the government’s books, so it was re-chartered to become a privately-held corporation, albeit one with special privileges. It then became a buyer of mortgages which were not FHA-backed (a function assumed by Ginnie Mae) and its explicit guarantee became an unwritten implicit guarantee. Changing the guarantee was a necessary condition to get Fannie off the government’s books and lower the government debt. Freddie Mac was created by the government in 1970 with the same mission as Fannie and to give Fannie competition. Freddie was privately-held from its inception.
The special privileges I just mentioned include the implied guarantees, which reduce Fannie and Freddie’s borrowing costs significantly – an advantage not possessed by its competitors in the private sector. The CBO estimated that this was worth about $2 billion annually. Moreover, Fannie and Freddie aren’t required to carry the capital reserves that others in the private sector must carry, increasing their financial leverage, which buoys earnings in good times and curses them in bad times. There are no SEC filing requirements for them, and neither institution is held to the same money market fund diversification standards as its private competitors are. Therefore, a fund manager may exceed the 5% limit and hold all of its assets in Fannie and Freddie debts if it wanted – because of its implicit guarantee from the federal government.
A person who really knew how to exploit these advantages to their limit was James A. Johnson, Fannie’s calculating and politically well-connected CEO. He was a foot soldier in the Viet Nam anti-war demonstrations, had worked in the failed presidential campaigns of Eugene McCarthy and George McGovern, and had been an advisor to Carter’s Vice President, Walter Mondale, later working on Mondale’s failed presidential bid. Johnson had been Bill Clinton’s roommate at Georgetown University. He was a political junkie whose career aspirations were totally political, hoping one day for a high position or office, perhaps White House chief of staff. (After Fannie, he aspired to be Secretary of the Treasury.)
In the mid-1980s of the Reagan years, Fannie was the target of shifting political winds in a “small government” administration set on squelching the privately-held institution’s government perks. Its CEO then was David Maxwell, a brilliant manager and leader, but no politician. He had met Johnson at one of Washington’s never-ending dinner parties. Johnson’s political connections could be helpful, he thought, so Maxwell asked Johnson to help fend off one of the many attempts to fully privatize Fannie. As 1990 approached and with it Maxwell’s retirement, he invited Johnson to become Fannie’s Vice Chairman, queuing him up as his replacement.
Lacking any business experience, particularly in the area of finance, Johnson took the helm of Fannie in 1990. He quickly grasped the potential of the money making machine he now ran, particularly if he could enlist the collaboration of Washington’s political class to fend off privatization efforts and any banking regulations that could interfere with his free-wheeling plans. Johnson would turn Fannie into a lobbying machine that at the same time engaged in self-promotion and fought off its enemies.
One of his first initiatives was to devote $10 billion to the “Open Doors to Affordable Housing.” The idea was to finance so much low income housing that Fannie’s federal perks could never be taken away. Thus, organizations like the Association of Community Organizations for Reform Now (ACORN) and similar low income advocacy groups, which had agitated for tighter regulations on Fannie, were bought off with “research” grants and invitations to sit on the Fannie Advisory Council, turning them into de facto lobbyists. Though most of the poor would surely be hurt most by turning them into homeowners, money is the great mollifier in quieting those agitating for the downtrodden.
When lawmakers, notably Democrat Rep. Henry Gonzalez, Chairman of the House Banking Committee and its subcommittee on housing and community development, wrote the laws to dictate the percentage of loans Fannie and Freddie must underwrite from low income and inner city families, ACORN was invited to sit at the table. ACORN had finally gained respectability.
The timing of Clinton’s 1994 Partners program was a godsend. ACORN used its research money to collect data showing that minority loan applicants were rejected many more times than whites. A researcher with the Boston Fed picked up the trail and published similar findings (although they were later found flawed, the critics were ignored.) Fannie fanned the racial flames to justify spending $7 billion on “underwriting experiments” – a euphemism for loosening underwriting standards for the low income loans it would buy on the secondary market. First to go were credit histories, then loan-to-income ratios. Down payments were lowered because the poor had a low propensity to save and it was thus discriminatory. Subprime entered the mortgage banking lexicon.
Having greatly reduced the underwriting standards of the mortgages Fannie and Freddie were willing to purchase after 1994, a predictable feeding frenzy among mortgage originators followed. Notable among them was Countrywide Financial. When Fannie announced its “Trillion Dollar Commitment,” a program to underwrite mortgages for ten million homes for low income families, it needed substantial suppliers of mortgages it could buy, and Countrywide was more than willing to fill the pipeline. Others – NovaStar, Fremont, and a gaggle of originators – would join later. But Countrywide Financial became Fannie’s single largest supplier of home mortgages and the nation’s largest lender, making a fortune for its co-founder, Angelo R. Mozilo. Mozilo wanted the elimination of down payments for low-income borrowers, along with paring back of documentation and paperwork so that loans could be approved “in minutes.” (It wouldn’t be long before he was abandoning underwriting standards altogether and doctoring mortgages so their applicants looked more creditworthy than they were.)
Mozilo’s business practices were risky and ill-advised. But unlike Fannie and Freddie, he was running a private sector for-profit business, and thus was free to offer his customers any and all enticements to use his money, provided he was willing to suffer the consequences when loans went sour. But Fannie was purchasing and implicitly guaranteeing over 25% of Countrywide’s mortgages. That’s hardly the same as operating in a free market.
Mozilo, the son of a Bronx butcher, was a co-founder of Countrywide Credit Industries in 1969, the predecessor to Countrywide Financial Corporation. A symbiotic relationship developed between Johnson and him, with Johnson allowing himself to be interviewed for the television program “The Countrywide Story” that aired in California in 1997 about the state’s leading entrepreneurs. In return, Mozilo let Johnson use his corporate jet to fly around the country, and Countrywide provided Johnson cut-rate mortgages to buy multi-million homes in Ketchum, ID; a penthouse atop the Washington, DC Ritz Carlton, and a home in Palm Desert, CA – homes he still owns and enjoys today.
In time, Mozilo would develop a VIP Friends of Angelo (FOA) program that would make sweetheart loans, not available to the average slug like you or me, nor to low income borrowers, but to such luminaries as Chris Dodd, Democrat Senate Banking Committee Chairman; Kent Conrad, Democrat Senate Budget Committee Chairman; Democrat Sen. Barbara Boxer; Democrat Diplomat Richard Holbrooke; Democrat HHS Secretary Donna Shalala; Republican Clinton Jones III, adviser to Republican members of Congress responsible for legislation of interest to Countrywide; Republican Alphonso Jackson, Bush’s acting secretary of HUD which regulated Fannie; Democrat Franklin Raines, Fannie Mae’s chairman after Johnson retired; the son of Democrat Nancy Pelosi; Republican Rep. Adam Putnam; Democrat Rep. James Clyburn; and 40 key employees and Directors of Fannie. Countrywide also gave Paul Pelosi, son of Nancy, a job.
Countrywide and other mortgage originators grew rapidly not only because they were the front end of the Fannie and Freddie growth engine, but also because the rising tide of the housing bubble, which Fannie and Freddie had a role in creating along with the Fed’s low interest rates, was raising all ships. This created extraordinary demand for new home construction and financing as well as demand for existing home refinancing. The latter all too often cashed out and spent the increased equity that price inflation caused.
On the back end of this growth machine was a nightmare in the making. Let me set the stage.
Fannie and Freddie and its competitors which bought mortgages on the secondary market couldn’t sit on those mortgages because they would have run out of capital to lend. Therefore, they bundled them into mortgage backed securities (MBS) and wholesaled them to Goldman Sachs, Lehman, J.P. Morgan, Citigroup, American International Group, and others which in turn retailed them to investors.
An MBS was structured in a tranche stack, and tranches were rated by Standard & Poor, Moody, and Fitch so they could be selected on the basis of the investor’s risk appetite. A “AAA” was at the top of the stack putting it first in line for the income stream. Since it took the least risk, it was paid the lowest return. A “BB” was the bottom tranche in the stack and would be last in line, but it received the highest return. It works well as long as borrowers repay their mortgages; therefore in the days before subprime mortgages, it really worked well. If homeowners failed to pay their mortgages, the last investor got hit first, but that’s why he got the highest yield.
As riskier mortgages appeared on the market – interest-only, adjustable rate mortgages, subprimes – their losses made it harder and harder to sell the lower tranches in a stack. If the entire stack couldn’t be sold, none of the stack could be sold. So the bright boys on Wall Street did what they do best – put lipstick on a pig. The unsalable lower tranches were repackaged with lower tranches from other MBSs. With a new wrapper on them called a collateralized debt obligation (CDO), this new product structure became the dumping ground for low rated tranches. The rating agencies didn’t really have a clue how to rate this risk or, in many cases, know what was in the CDO. It might contain mortgages but it could also contain credit card debt, used car loan, and other types of asset-backed obligations.
A CDO manager would take a pile of “BB” tranches from many MBSs and convert the pile into a CDO. All of the investors in that CDO would be taking a “BB” risk, but they would also be getting, collectively, a “BB” return. The CDO investors would line up by rating so that the “AAA” would be first in line but would get the smallest share of the income stream, whereas the “BB” investors would be last in line but get the largest share of the income stream.
You don’t have to be a financial wizard to wonder what in the world is “AAA” about a “BB” tranche, but you’d soon realize that it has little to do with an investment quality rating and more to do with payment priority and return. Too bad the investors didn’t understand this. Investors don’t mind risk as long as they can price it. But those who relied on the ratings agencies to vet the CDOs never had a chance. In the first place, the ratings agencies didn’t know how toxic the CDO was because they didn’t do a loan-level analysis of what was inside. And in the second place, it likely would have done little good. The CDO structure was too complex to be understood by outsiders because they contained dozens, if not hundreds, of pieces of multiple loan bundles made up of thousands of mortgages.
The gospel of the CDO is that it diversified risk. But if the starting point is a low quality obligation – a subprime mortgage – cutting it into little pieces to diversify it doesn’t improve its quality. In truth, CDOs made it possible to create demand for bad mortgages, prolong this shell game, magnify the losses investors would ultimately take, and increase the size of the bailout of firms like Citi and AIG in taxpayer dollars. In the end, CDOs were a house of cards if an extraordinary number of people stopped paying their mortgages. CDO values could (and did) evaporate overnight.
But greed often overwhelms good sense and investors lined up to buy these exotic instruments because they offered above-market yields.
More next week.
—William Jefferson Clinton, November 1994
So begins the recently released book, Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon, by Gretchen Morgenson and Joshua Rosner. Morgenson is a business reporter and columnist for the New York Times, and Rosner is a housing and mortgage finance consultant.
I have just finished reading it, and as bad as I thought the 2008 financial markets meltdown was, it was worse. The book depicts a tale of corruption, vote buying, governmental intimidation, and complicity between key government leaders, Wall Street firms, the executives of Fannie Mae and Freddie Mac, and regulators who tag-teamed to hornswoggle the American taxpayer – apparently legally because none of them has been charged with a wrong-doing.
How did it happen? I will devote this and my next blog to answering that question.
Two years into his first term, Clinton spoke to a fawning audience at the National Association of Realtors' annual meeting in Washington, D.C. and announced a new program, National Partners in Homeownership, a private-public collaboration whose goal would be to raise home ownership from its mid-1990s level of 64% to a hoped-for 70% in 2000.
Never before had regulators teamed up with those they were regulating, as would be necessary in the Clinton program. Unanticipated was the impact of loosening the home-buying rules to accomplish program’s goal – reduced down payments, historically the way to assure home buyers had substantial skin in the game; risky loan-to-value ratios; less due diligence on the borrower’s creditworthiness; and relaxation of the applicant’s debt-to-income ratios, which disqualified some aspiring homeowners and prevented others from taking on more home than they could afford.
Unchallenged and unexamined was the economic value of increasing the national home ownership six points, destabilizing the natural growth in housing demand and production, using government subsidies (which in the end are taxpayer financed) to create an inevitable bubble while inducing people to take on a strange new obligation for them – a home mortgage – for which they lacked the means and economic discipline to repay or sophistication to understand. Just as a college education is not for everyone, neither is home ownership. Improving access isn’t the problem.
Yet, the foregone conclusion of the Clinton program was that access problems had indeed locked out otherwise deserving people from home ownership, and that was to be the focus of Fannie Mae and Freddie Mac – two quasi-governmental institutions that facilitated the country’s home ownership.
Fannie Mae is a relic of the Roosevelt New Deal. The Federal National Mortgage Association (FNMA cum Fannie Mae) was created in 1938 during the height of the Great Depression. Originally its purpose was to provide local banks with federal money to finance home mortgages in an attempt to raise levels of home ownership and the production affordable housing. Fannie Mae provided loan originators a secondary market to sell FHA-approved mortgages. In 1968, with the cost of the Viet Nam war increasing the national debt, Lyndon Johnson wanted to get Fannie Mae off of the government’s books, so it was re-chartered to become a privately-held corporation, albeit one with special privileges. It then became a buyer of mortgages which were not FHA-backed (a function assumed by Ginnie Mae) and its explicit guarantee became an unwritten implicit guarantee. Changing the guarantee was a necessary condition to get Fannie off the government’s books and lower the government debt. Freddie Mac was created by the government in 1970 with the same mission as Fannie and to give Fannie competition. Freddie was privately-held from its inception.
The special privileges I just mentioned include the implied guarantees, which reduce Fannie and Freddie’s borrowing costs significantly – an advantage not possessed by its competitors in the private sector. The CBO estimated that this was worth about $2 billion annually. Moreover, Fannie and Freddie aren’t required to carry the capital reserves that others in the private sector must carry, increasing their financial leverage, which buoys earnings in good times and curses them in bad times. There are no SEC filing requirements for them, and neither institution is held to the same money market fund diversification standards as its private competitors are. Therefore, a fund manager may exceed the 5% limit and hold all of its assets in Fannie and Freddie debts if it wanted – because of its implicit guarantee from the federal government.
A person who really knew how to exploit these advantages to their limit was James A. Johnson, Fannie’s calculating and politically well-connected CEO. He was a foot soldier in the Viet Nam anti-war demonstrations, had worked in the failed presidential campaigns of Eugene McCarthy and George McGovern, and had been an advisor to Carter’s Vice President, Walter Mondale, later working on Mondale’s failed presidential bid. Johnson had been Bill Clinton’s roommate at Georgetown University. He was a political junkie whose career aspirations were totally political, hoping one day for a high position or office, perhaps White House chief of staff. (After Fannie, he aspired to be Secretary of the Treasury.)
In the mid-1980s of the Reagan years, Fannie was the target of shifting political winds in a “small government” administration set on squelching the privately-held institution’s government perks. Its CEO then was David Maxwell, a brilliant manager and leader, but no politician. He had met Johnson at one of Washington’s never-ending dinner parties. Johnson’s political connections could be helpful, he thought, so Maxwell asked Johnson to help fend off one of the many attempts to fully privatize Fannie. As 1990 approached and with it Maxwell’s retirement, he invited Johnson to become Fannie’s Vice Chairman, queuing him up as his replacement.
Lacking any business experience, particularly in the area of finance, Johnson took the helm of Fannie in 1990. He quickly grasped the potential of the money making machine he now ran, particularly if he could enlist the collaboration of Washington’s political class to fend off privatization efforts and any banking regulations that could interfere with his free-wheeling plans. Johnson would turn Fannie into a lobbying machine that at the same time engaged in self-promotion and fought off its enemies.
One of his first initiatives was to devote $10 billion to the “Open Doors to Affordable Housing.” The idea was to finance so much low income housing that Fannie’s federal perks could never be taken away. Thus, organizations like the Association of Community Organizations for Reform Now (ACORN) and similar low income advocacy groups, which had agitated for tighter regulations on Fannie, were bought off with “research” grants and invitations to sit on the Fannie Advisory Council, turning them into de facto lobbyists. Though most of the poor would surely be hurt most by turning them into homeowners, money is the great mollifier in quieting those agitating for the downtrodden.
When lawmakers, notably Democrat Rep. Henry Gonzalez, Chairman of the House Banking Committee and its subcommittee on housing and community development, wrote the laws to dictate the percentage of loans Fannie and Freddie must underwrite from low income and inner city families, ACORN was invited to sit at the table. ACORN had finally gained respectability.
The timing of Clinton’s 1994 Partners program was a godsend. ACORN used its research money to collect data showing that minority loan applicants were rejected many more times than whites. A researcher with the Boston Fed picked up the trail and published similar findings (although they were later found flawed, the critics were ignored.) Fannie fanned the racial flames to justify spending $7 billion on “underwriting experiments” – a euphemism for loosening underwriting standards for the low income loans it would buy on the secondary market. First to go were credit histories, then loan-to-income ratios. Down payments were lowered because the poor had a low propensity to save and it was thus discriminatory. Subprime entered the mortgage banking lexicon.
Having greatly reduced the underwriting standards of the mortgages Fannie and Freddie were willing to purchase after 1994, a predictable feeding frenzy among mortgage originators followed. Notable among them was Countrywide Financial. When Fannie announced its “Trillion Dollar Commitment,” a program to underwrite mortgages for ten million homes for low income families, it needed substantial suppliers of mortgages it could buy, and Countrywide was more than willing to fill the pipeline. Others – NovaStar, Fremont, and a gaggle of originators – would join later. But Countrywide Financial became Fannie’s single largest supplier of home mortgages and the nation’s largest lender, making a fortune for its co-founder, Angelo R. Mozilo. Mozilo wanted the elimination of down payments for low-income borrowers, along with paring back of documentation and paperwork so that loans could be approved “in minutes.” (It wouldn’t be long before he was abandoning underwriting standards altogether and doctoring mortgages so their applicants looked more creditworthy than they were.)
Mozilo’s business practices were risky and ill-advised. But unlike Fannie and Freddie, he was running a private sector for-profit business, and thus was free to offer his customers any and all enticements to use his money, provided he was willing to suffer the consequences when loans went sour. But Fannie was purchasing and implicitly guaranteeing over 25% of Countrywide’s mortgages. That’s hardly the same as operating in a free market.
Mozilo, the son of a Bronx butcher, was a co-founder of Countrywide Credit Industries in 1969, the predecessor to Countrywide Financial Corporation. A symbiotic relationship developed between Johnson and him, with Johnson allowing himself to be interviewed for the television program “The Countrywide Story” that aired in California in 1997 about the state’s leading entrepreneurs. In return, Mozilo let Johnson use his corporate jet to fly around the country, and Countrywide provided Johnson cut-rate mortgages to buy multi-million homes in Ketchum, ID; a penthouse atop the Washington, DC Ritz Carlton, and a home in Palm Desert, CA – homes he still owns and enjoys today.
In time, Mozilo would develop a VIP Friends of Angelo (FOA) program that would make sweetheart loans, not available to the average slug like you or me, nor to low income borrowers, but to such luminaries as Chris Dodd, Democrat Senate Banking Committee Chairman; Kent Conrad, Democrat Senate Budget Committee Chairman; Democrat Sen. Barbara Boxer; Democrat Diplomat Richard Holbrooke; Democrat HHS Secretary Donna Shalala; Republican Clinton Jones III, adviser to Republican members of Congress responsible for legislation of interest to Countrywide; Republican Alphonso Jackson, Bush’s acting secretary of HUD which regulated Fannie; Democrat Franklin Raines, Fannie Mae’s chairman after Johnson retired; the son of Democrat Nancy Pelosi; Republican Rep. Adam Putnam; Democrat Rep. James Clyburn; and 40 key employees and Directors of Fannie. Countrywide also gave Paul Pelosi, son of Nancy, a job.
Countrywide and other mortgage originators grew rapidly not only because they were the front end of the Fannie and Freddie growth engine, but also because the rising tide of the housing bubble, which Fannie and Freddie had a role in creating along with the Fed’s low interest rates, was raising all ships. This created extraordinary demand for new home construction and financing as well as demand for existing home refinancing. The latter all too often cashed out and spent the increased equity that price inflation caused.
On the back end of this growth machine was a nightmare in the making. Let me set the stage.
Fannie and Freddie and its competitors which bought mortgages on the secondary market couldn’t sit on those mortgages because they would have run out of capital to lend. Therefore, they bundled them into mortgage backed securities (MBS) and wholesaled them to Goldman Sachs, Lehman, J.P. Morgan, Citigroup, American International Group, and others which in turn retailed them to investors.
An MBS was structured in a tranche stack, and tranches were rated by Standard & Poor, Moody, and Fitch so they could be selected on the basis of the investor’s risk appetite. A “AAA” was at the top of the stack putting it first in line for the income stream. Since it took the least risk, it was paid the lowest return. A “BB” was the bottom tranche in the stack and would be last in line, but it received the highest return. It works well as long as borrowers repay their mortgages; therefore in the days before subprime mortgages, it really worked well. If homeowners failed to pay their mortgages, the last investor got hit first, but that’s why he got the highest yield.
As riskier mortgages appeared on the market – interest-only, adjustable rate mortgages, subprimes – their losses made it harder and harder to sell the lower tranches in a stack. If the entire stack couldn’t be sold, none of the stack could be sold. So the bright boys on Wall Street did what they do best – put lipstick on a pig. The unsalable lower tranches were repackaged with lower tranches from other MBSs. With a new wrapper on them called a collateralized debt obligation (CDO), this new product structure became the dumping ground for low rated tranches. The rating agencies didn’t really have a clue how to rate this risk or, in many cases, know what was in the CDO. It might contain mortgages but it could also contain credit card debt, used car loan, and other types of asset-backed obligations.
A CDO manager would take a pile of “BB” tranches from many MBSs and convert the pile into a CDO. All of the investors in that CDO would be taking a “BB” risk, but they would also be getting, collectively, a “BB” return. The CDO investors would line up by rating so that the “AAA” would be first in line but would get the smallest share of the income stream, whereas the “BB” investors would be last in line but get the largest share of the income stream.
You don’t have to be a financial wizard to wonder what in the world is “AAA” about a “BB” tranche, but you’d soon realize that it has little to do with an investment quality rating and more to do with payment priority and return. Too bad the investors didn’t understand this. Investors don’t mind risk as long as they can price it. But those who relied on the ratings agencies to vet the CDOs never had a chance. In the first place, the ratings agencies didn’t know how toxic the CDO was because they didn’t do a loan-level analysis of what was inside. And in the second place, it likely would have done little good. The CDO structure was too complex to be understood by outsiders because they contained dozens, if not hundreds, of pieces of multiple loan bundles made up of thousands of mortgages.
The gospel of the CDO is that it diversified risk. But if the starting point is a low quality obligation – a subprime mortgage – cutting it into little pieces to diversify it doesn’t improve its quality. In truth, CDOs made it possible to create demand for bad mortgages, prolong this shell game, magnify the losses investors would ultimately take, and increase the size of the bailout of firms like Citi and AIG in taxpayer dollars. In the end, CDOs were a house of cards if an extraordinary number of people stopped paying their mortgages. CDO values could (and did) evaporate overnight.
But greed often overwhelms good sense and investors lined up to buy these exotic instruments because they offered above-market yields.
More next week.
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