How Wall Street Got Rich on Bum Mortgages, and Might Do It Again

Wall Street turned crummy mortgage loans into a pot of gold. How did that happen? Fraud charges against Goldman Sachs, filed by the Securities and Exchange Commission, gave the public its first peek at the game. So did Michael Lewis's must-read new book, "The Big Short," about a handful of the clever people who bet against the bubble.

Their secret? First, they figured out how to short the market -- that is, bet big on the likelihood that large numbers of subprime mortgage holders were going to default. Second, even when they were wrong they got to keep the money. Here's a pocket guide to what was going on, and how other financial markets could fall unless Congress stops the game:

The chain began with real mortgage loans, made to borrowers with mediocre credit. Groups of mortgages were packaged into high-yield securities by the big banks. The banks split the securities (now called Collateralized Debt Obligations or CDOs) into several pieces (called tranches), each one designed to carry a different level of risk.

At the top were pieces considered "safe." The investors who bought them were paid first when borrowers made their monthly payments on the loans. The rating agencies -- Moody's, Standard & Poor's, and Fitch -- shut their eyes, held their noses, and blessed this type of paper with quality ratings of AAA and AA. In the world of corporate and municipal bonds, ratings like that amount to a virtual sure thing.

The lower quality pieces of these mortgage-backed securities took the first losses when borrowers didn't pay. Nevertheless, they got BBB ratings, still an investment grade. The raters figured that the interest rates were high enough to cover the number of loans expected to default.

Oops.

In the real world, every piece of these securities -- from AAA to BBB -- was backed by crummy mortgages, all of them equally likely to default. There was nothing Triple A about any them. The rating organizations charged fat fees for saying otherwise (even when warned by internal memos that the ratings were wrong).

Try as they might, however, the lenders couldn't make enough stupid mortgage loans to meet the raging, global demand for American real estate. So they bundled the bundles into new securities, sliced them into new pieces, and sold them again.

These are the derivatives you keep reading about. The original securities were backed by real mortgages, even though they were flaky ones. The new "synthetic" securities were bets on what various pieces of the original mortgage securities might be worth. Because they were only bets -- like gaming table bets -- the supply was infinite. Speculators hedged their bets by buying insurance against the risk that the mortgages would default (the insurance is called a credit default swap).

As the credit bubble bulged, a few players started to sniff the brimstone. Instead of buying mortgage CDOs and collecting monthly payments, they wanted to bet that the subprime mortgage pools would fail. Synthetic securities let them do it. They could buy insurance that paid off if certain mortgages went into default.

That's what's behind the SEC's case against Goldman Sachs. A hedge fund, Paulson & Co., helped create a CDO security, based on terrible mortgages that were almost sure to fail. Paulson bet on its failure. Goldman sold the security to a German bank, among others, without disclosing Paulson's strategy.

The CDO lost most of its value within months. The investors lost $1 billion and Paulson gained about the same amount. The SEC called the transaction fraud (you can read the complaint here). Goldman says that the bank had a list of all the securities in the pool and was able to look after itself. Read its response here.

Whatever the outcome of the case, it's clear that derivatives sparked the 2008 financial collapse. The funny thing is that, except for the homeowners, everyone else got rich on the deal. The shorts made money, and so did the traders who sold and bought derivatives. Some of their companies collapsed (e.g., Lehman Brothers and AIG), but the perps kept their tens of millions and walked away.

The Goldman transaction, and those like it, have no social benefit, says financier George Soros. Their primary purpose, he says, is "to generate fees and commissions." He thinks that the current Senate bill, forcing derivatives to be traded on a public exchange, isn't nearly good enough. Derivatives should be registered with the SEC or the Commodities Futures Trading Commission, he says, like any other security.

Soros calls credit default swaps a "license to kill." If a House-Senate conference waters down even the current half-measure on derivatives, you can bet that the fat cats will kill again.

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