made, and thus take all the risk off the banksâ books, there was no reason for the banks not to try to lend to anyone who asked them for cash. At the height of the insanity, loans were being given to practically anyone despite obvious red flags: lies on an application, a history of bad credit ratings, even lack of a job. Thereâs also evidence that loan officers would simply rewrite applications to change or eliminate negative information that would prevent the loan from being accepted because the banks knew they could dump the mortgage on Fannie and Freddie the minute the papers were signed.
Fannie and Freddie would then make these loans, or guarantee them, so they could be processed into bondsâcombining the streams of income from many of these mortgages into a single security known as a mortgage bond, which they would sell to investors, earning enormous profits in the process for the chosen Wall Street firms that conducted the bond sales to finance Fannieâs and Freddieâs operations. The firms kept many of these bonds on their own books as well, because they earned such tremendous returns.
The beauty of the whole process, the thing that made investors snap these loans up whenever they could get their hands on them, was that because the mortgages that went into these bonds were made to risky borrowers, they carried high rates of interest, meaning the bonds in turn would generate high yields, or returns, for their owners. Normally in the world of finance, high returns imply high levels of risk as well, but the compliant ratings agencies happily gave these bonds their coveted triple-A rating, the same rating given to the safest bonds in existence, U.S . Treasury bonds. Because these bonds were composed of so many mortgages, which were unlikely to go into default at once, investors were led to believe they were safe.
But as any farmer can tell you, if you take a lot of pieces of horseshit and put them together, what you get is nothing more than a big pile of horseshit. And the bonds, no matter how many mortgages were in each of them, were still composed of thousands and thousands of shitty loans made to people who should never have been given mortgages in the first place.
Whatâs more, the financial firms, looking to increase profits even more, got more and more creative with their financial engineering, developing new bonds composed not of mortgages themselves but of other mortgage bonds; at the peak, just before the collapse began in 2007, the firms were even selling bonds that were composed of other mortgage bonds that were in turn composed of the mortgages themselves. So one mortgage made to one risky borrower could end up as part of a whole stew of crazy financial instruments (all unbeknownst to the original borrower, of course).
While the mortgage bond opened the housing market to the masses, it ironically made housing less affordable; prices shot up because just about anyone could get a loan that would be packaged by Wall Street into a seemingly risk-free security. The rest of the story is known to anyone whoâs not been living in a cave for the past several years: The housing bubble created by this furious borrowing and lending eventually burst as people realized the inflated prices of so much American real estate bore little or no relation to its actual value. As a result, many of the insane subprime mortgages went belly up as well, and with that, in a chain reaction, so did the value of the bonds based on those mortgages, the value of the bonds based on those other bonds, and so on.
This, of course, is the Readerâs Digest version of how the crisis worked. Anyone interested in exploring the sheer lunacy of the process in more detail might enjoy reading any of the many books on the crisis, which make for fascinating and depressing reading.
But my goal is not to do what these other books have already done, so letâs return to Johnnyâs Half Shell.
As Gallogly and all