What on earth happened?

Today I'm going to attempt to tackle something that's perhaps the most poorly understood part of the financial crisis  - the central role of the bond and derivatives markets in causing the crisis. This is going to get complicated, but I'll try to keep it as simple as possible was explaining it as accurately as I can.

I'm going to speak specifically of consumer credit bonds and credit derivatives. And I'm going to simplify where necessary.

To catch you up with some basic concepts, bonds are essentially extensions of credit to governments, corporations, or credit markets.

A government bond is pretty straight forward and extremely secure investment. When the federal government runs a budget deficit, they sell bonds to investors to cover the cost over-run. The government then pays back those bonds with interest to the investors. The federal government has never defaulted on these bonds - thus they are considered the safest investment in the bond market. Nearly risk free, or AAA rated.

Corporate bonds are not quite as safe, but essentially the same concept. If a corporation needs additional revenue to expand their operations, cover losses during a quarter, etc. they will work with an investment bank to create a corporate bond. The bond investors are then paid back with interest by the corporation. The only way for these bonds to go bad would again be if the corporation defaulted, which would essentially result in a bankruptcy. So the bond holders only lose out if the company goes belly up. Corporate bonds, particularly those to blue chip companies such as Microsoft or Proctor & Gamble, represent nearly risk free investments, or AAA rated.

Consumer credit bonds are a different animal. Investment banks began buying up consumer debt - credit card balances, auto loans, student loans, mortgages, and began bundling them into bonds. Let's focus specifically on mortgage bonds since the housing market was the fundamental driver of the financial crisis.

Traditionally, when a bank lent a home buyer the money to buy a home, the bank held the mortgage and the buyer paid back the loan over time. Most of these transactions were conducted by local banks and they only gave loans to credit worthy customers who were deemed able to pay back the loan on their house. The banks had an incentive to create mortgage terms that would optimize the likelihood that the buyer could pay back the loan in full.

As our banking system became more and more complex and our economy grew, national mortgage companies began issuing home loans. And in order to issue more and more credit to home buyers (these companies earned fees on each originated loan so increasing the number of loans was important), these national mortgage companies began selling off mortgages to other banks. These banks then began creating mortgage-based bonds. These were pools of thousands of mortgages, which made them safer than buying individual mortgages. If you owned one mortgage and the buyer defaulted, you'd lose approximately 50% of your investment after the foreclosure was processed. But if just a few mortgages within the mortgage bond defaulted, those losses would be more than covered by the interest payments of the thousands of other mortgages within the bond, which hadn't defaulted. It took a substantial number of defaults for the bond to fail.

This was all well and good at the beginning of this process. The mortgages being initiated and bundled into these bonds were very much like the mortgages traditionally given to buyers by local banks. The buyers had high credit ratings and a low risk of default. The ratings agencies (Standard & Poors, Moody's, and Fitch in the U.S.) gave these mortgage bonds similar AAA ratings, just as they'd give to all federal government and many corporate bonds.

But the ability to sell off the loans mortgage companies originated, changed their incentives. They no longer held the risk of default - they'd passed it off to a buyer. They were immune to the effects of a default. They quickly realized that they could increase their profits by doing two things. One was giving loans to people who they would not have given them to if they held the risk - and the other was to push people into adjustable rate mortgages, which were designed to require refinancing once the introductory teaser rates expired and the mortgage payments went up.

This combination of lowering credit standards and a preference for adjustable rate mortgages lead to the subprime mortgage phenomenon. Lending credit to the least credit worthy customers and pushing them into loans that would require them to refinance within a couple years. This was predatory and nobody cared. The customers got access to easy credit to either buy homes or refinance their existing homes (to use the equity to pay down other debt or buy nice things). Anybody remember the ubiquitous advertising from The Money Store and other companies promising to combine customer's credit card, car loan, and mortgage debt into a single low monthly payment? Those were subprime lenders. They'd prey on people with overextended credit or poor credit ratings.

But they kept selling those mortgages to the banks creating the consumer credit bonds. And the banks began stratifying the morgagess by their creditworthiness. Traditional mortgage bonds remained traditional mortgage bonds - those made up of mortgages that were least likely to default. But these subprime mortgages were then bundled into similar bonds, but made up of lower credit worthy loans that were substantially more likely to default. And a curious thing happened. The credit rating agencies still gave AAA ratings to many of these bonds ... essentially claiming that the bonds were nearly risk free - giving them the same ratings as federal government bonds.


A quick breakdown of bond ratings can be found HERE.

Investment banks who originated these bonds needed their bonds to be investment grade - many public pensions and other investment houses were prohibited from buying bonds that did not meet certain ratings thresholds - for the biggest institutional investors these are often AA or AAA only. So had the subprime mortgage bonds been rated lower than that, the market for these bonds would have been much smaller. But since the ratings agencies were giving AA or AAA ratings to a full 70 or 80% of these subprime mortgage bonds, there was a robust market for them.

And the investment banks quickly realized they could save those mortgage bonds that were given lower ratings. They took these B rated bonds and repackaged them into collateralized debt obligations, or CDOs. These were pools of subprime mortgage bonds put together to create a new derivative. The concept was the same as going from holding a single mortgage to a mortgage bond ... holding a pool of bonds was considered substantially less risky than holding a single mortgage bond. As such, the ratings agencies again gave 70 or 80% of these CDOs AA or AAA ratings. They took the worst of the mortgage bonds, the B rated crap, and repackaged them into investment grade derivatives.

Remember, AAA rated bonds and CDOs were considered virtually risk free. Yet they were made up of large pools of subprime adjustable rate mortgages given to the least credit worthy home buyers. These were ticking time bombs. And they were being packaged and sold to pensions, hedge funds, institutional investors, college endowments, etc.

A few very savvy investors realized what was happening. They didn't necessarily fully understand the details, but they knew that these subprime mortgages represented the least credit worthy customers and that they had been largely enticed into adjustable rate mortgages with introductory teaser rates that usually lasted 2 years. That meant in 2 years one of two things were going to happen - the homeowners were going to refinance or they were going to default.

Enter the credit default swap or CDS. The credit default swap is pretty simple. It's an insurance policy on a bond or derivative. The buyer of a CDS believes that the bond is at risk of default and is buying insurance against that happening. The CDS is usually sold as a percentage of the presumed value of the bond and is renewable yearly. By way of example, if you wanted to buy a CDS on $1 billion worth of a AAA-rated subprime mortgage bond you might pay 0.5% of that value per year. So you'd essentially pay $5 million to insure the bond against default for one year. If the bond defaulted during that year, you'd get paid $1 billion. If it did not default during that year you'd be out $5 million. So essentially it becomes a bet. The buyer of a CDS is betting the odds of a bond defaulting during that year. Now the CDS holder can renew the CDS every year for the life of the bond (mortgage bonds exist until all buyers have either defaulted or paid off their loans). So if you believed there was a high likelihood that the AAA-rated subprime mortgage bond would default within 5 years, it'd cost you $25M to make that bet. And the payoff if you were right would be $1B. To put it into our level of financial understanding, you'd be spending $25 in insurance over 5 years for a chance to win $1,000. If you believed the bet would pay off within 5 years you'd be a fool not to make that bet, right?

And here's the kicker. Unlike traditional insurance, with a CDS you did not need to own the underlying property. I can't buy fire insurance on your house - I can only buy it on my own house. Otherwise, I'd have an incentive to burn your house down. Also, if we both held fire insurance on your house and it burnt down, the insurance company would have to pay both of us for a single property. That's an absurd way of doing business, but that's exactly how CDSs work. You could buy CDS against bonds or CDOs you didn't actually own.

Well, the smart guys in finance realized that particularly the AAA-rated subprime CDOs were absolute crap. That their likelihood of defaulting was not almost impossible ("nearly risk free") but were virtually certain. These smart guys leveraged as much of their investment portfolios as possible buying very cheap CDSs on these AAA-rated CDOs.

Things get much more complicated than this, but ultimately investment banks that were leveraged heavily in these CDSs for subprime bonds and CDOs were on the hook for hundreds of billions of dollars when these subprime bonds and CDOs began defaulting en masse. You see, the sellers of the credit default swaps did not need to hold capital equivalent to their exposure so once these bonds stated crashing like the junk they were, these banks did not have the capital necessary to pay out the insurance policies they'd sold. Not only that, but the bonds and CDOs they were holding became worthless overnight.

In other words, the CDS buyers broke the bank at the casino.

And the American taxpayers were on the hook for the costs, because if the bond and derivatives markets crashed, credit markets would freeze and the entire economy would collapse. These investment banks that so terribly misjudged the risks inherent in their gambles were too big to fail. Trillions of dollars of investment grade securities evaporated and the biggest losers were the institutional investments that were required to invest in only investment grade bonds or CDOs. Those pension plans, university endowments, etc. They'd been betrayed by the very banks they were supposed to be trusting to insure their solvency.