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Who is to blame for this mess?

There seems to be a lot of discussion to who is to blame for the financial crisis. But an awful lot of the media coverage is highly misleading. Here is synopis:

1) The meltdown in the financial market had little to do with people getting mortgages they couldn't afford. The collapse of the mortgage backed CDO's was caused by the collapse in the value of the houses which provided the collateral. It turned the mortgages behind the "collateralized debt obligations" (CDO's) into mostly un-collateralized debts. The result was that they went from AAA rated bonds to junk.

2)So what caused the housing bubble and collapse? Many people blame the fed, but don't have the story right. The fed did play a role. By keeping interest rates on Treasury Bonds low, they provided a market for alternative bonds that would pay a greater return.

But the major cause of the housing bubble was the creativity of the investment banks. These are not the retail banks that make home mortgages no matter what their size, whether Grand Rapids State Bank or US Bank. To meet the demand for a high interest AAA rated investment, the investment banks figured out how to disguise risky real estate investments in complex securities that would meet the rating services criteria as the equivalent of government bonds.

They accomplished that by purchasing mortgages backed by real estate, instead of investing directly in the real estate. Then they pooled the mortgages and created several different "tranches" - tranch is a fancy word for slice. These are not slices as a pie, but rather layers in a cake. The top layer of lenders gets paid first, then the next layer etc. In theory this makes the risk for the top layer very low.

Think of tranches this way. If you have a mortgage and home equity loan, when you sell your house the mortgage holder gets all of what they are owed first, then the home equity lender gets paid and finally you get whatever is left. Bond tranches work the same way.

Unfortunately, as people went under water on their loans the value of the underlying real estate no longer even covered the AAA bonds. Even if people were still paying their mortgage, the bonds were no longer secured debt. They all dropped to junk status.

In the mean time, a there was a lot of money going into real estate. Mortgages became a valuable commodity. And the availability of cheap credit meant people could afford a much larger mortgage with the same monthly payment. To those of use borrowing it felt like we could afford a lot more house, but the reality was we were buying the same house at a much higher price. Of course for people who already owned a home that meant their house was worth a lot more.

The flood of cheap money provided by Goldman and the other investment banks new investment vehicles had launched the housing bubble. Of course "irrational exhuberance" played a role. Some people took advantage of the low interest rates and increased home equity to borrow against their home for other things. This was, misleadingly, called "taking money out" of your house. But, as people discovered when housing prices fell, they were really just borrowing more money. Others bought investment properties and treated them like ATM machines, borrowing against their value.

As the bubble grew, the loan originators became more and more creative in figuring out how to make mortgages appear affordable even as housing prices sky-rocketed. Nothing down, interest only loans, negative amortization loans, stated income loans - there is a long list of now infamous "toxic" loans. But these were the result of the demand created by Goldman and the other investment banks. Their creative investments did not really depend on the ability of people to repay the mortgages. Their ability to create bonds depended on mortgages backed by the value of the real estate. Whether people could afford the payments or not was of little importance. By the end of the bubble predatory lending became almost the norm.

Of course, like all bubbles, this one burst when they ran out of people who could pay increasingly higher prices even with creative loans. The market shifted from a sellers market to a buyers and prices started to drop. This is where the familiar media narrative picks up.

But the focus on the end game, misses the central reality. This was a classic pump and dump. Goldman (and others) figured out how to disguise risky real estate investments as safe AAA bonds. In the process they drove up housing prices and that made their real estate investments as bonds even more attractive. When the bubble reached its peak, they bailed out, transferring any of the risk they still owned and betting on their own products to fail.

4) This brings us to the next phase. Because not only were there enormous losses in the real estate market that hit every home owner. But the investment banks had created even more complex derivatives that leveraged the losses on housing. These were really pure gambles, sidebets on what people expected the bonds to do.

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