The Subprime MessI think I disagree on the thinking behind the Bear Stearns debacle, although probably not about the end result. Easy money and low interest rates give you low investment returns as well. Especially when interest rates have fallen, investors will be desperate for more return. Since risk is seen to be low, the investment community will come up with lots of ways to spend your money. So stock and asset bubbles form. Many investors knew the housing mania was going to end in tears (they usually do), but the timing is never known in advance. There's also the possibility the thing will go up for much longer than you expect. The problem this time around was the invention of the CDO. This allowed banks and other mortgage originators to make loans without worrying about the long-term prospects of the borrower. They just repackaged the loans as CDOs and resold them to the broader market. By arranging them in tranches, they satisfied both institutional investors who wanted high quality and more risk-tolerant investors who would take the subprime, "equity" tranches. The Feds (including Greenspan) thought this was wonderful, since it made a much larger pool of investment money available to borrowers, and spread the risk of default much wider. A single bank making mortgage loans in a single community is very exposed to local downturns. Rapid interest rate changes were also a worry (remember the 80's S&L crisis.) A world-wide community of investors supplying funds for loans all over the country is much less exposed to downturns. A single CDO could even span the whole country, greatly reducing the impact of local events. Even in the case where the whole country went into downturn, the top tranches (best credit rating) would be nearly unaffected, and the losses from the bottom tranches (subprime) would be spread over the entire world, rather than bringing down a large lender. This is good because a large lender might be the counterparty to many other transactions. Killing one of them could kill other parties, in a domino effect. Giving all investors a minor haircut because of subprime losses would not have repercussions. Unfortunately, the CDO, by unlinking the source of the money (the investors) from evaluation of risk (the mortgage originator) was an invitation to fraud. No-doc loans, ARMS that reset after 3 years, 100% loans, cash-back loans, bogus appraisals, house flippers, etc. all grew like weeds in an environment where the lender wasn't (ultimately) playing with his own money. As long as the price of housing was going up 10-20% a year, there was nothing to worry about. The huge profits obtained by selling even 3 year old loans would cover any possible losses from poor credit quality. This attitude was widespread - "don't worry if you can't afford the loan after reset, you can refinance in 3 years with the 30% equity you'll have by then!" I'm not sure of the role of the rating agencies. It's possible that all they were doing was evaluating the structure of the CDOs, saying in effect, if the top tranch is really all low LTV, high credit rating customers, then this CDO tranch has AA rating. I don't think they were ever inspecting the actual mortgages underlying the CDOs. It hardly mattered given the mania for housing, and the amount of easy money looking for high returns. None of the CDOs had a long history, but none of them were going bust either. Then the housing bubble ends and the tide turns. As with the real estate market itself, the transactions lock up. No seller wants to drop his price when they've been going up, and no buyer wants to pay peak prices when he's sure they are going down. Similarly, no investor wants to trade a CDO and find out what it's really worth, and no buyer wants the things because he suspects they are toxic. So they don't trade and are not marked to market. Meanwhile, since everyone suspects they are sitting on a load of trash, they pressure everyone involved to avoid making the truth obvious. On the one hand, this is the lying you describe. On the other hand, it's also temporary cover. You know that behind the scenes, people are not just holding their breath and waiting for it all to collapse. They are frantically trying to unwind positions or buy hedges for this junk they know is going to be worthless. Someone is undoubtedly selling this stuff under the table somewhere, just to get rid of it before it's obvious that it's trash. The thing will collapse when some fund gets in big enough trouble that they are forced to sell everything, including the CDOs. This is what happened to Bear Stearns, and the natural response of everyone involved is to bail them out, buy up the assets privately, or find some way to keep CDO prices from being made public. Because when that happens, the game is up. Yes, it's dishonest, and yes, the small investor (or idiot pension fund manager) will be the last to know. On the other hand, the top guys (including the Fed) always think that if only they can let the air out slowly, they will avoid the wreckage that comes with a sudden collapse. And of course, everyone involved thinks they can save their own hides.
The game will end soon, when yet another fund is in trouble and
there's no bailout money left. At that point, it will be a rush
to the exits.
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