How Did We Get Here? Part II - Mortgage Market Woes

by Amy Lillard

This year has been a year of ups and downs for the housing market. In our continuing series, we chronicle news affecting the housing market and its major players.

With Greenspan's interest rate slashing in 2001, money was cheap and easy to be had. Risk was a minor concern that had no place in the booming economy, and in the racing-ever-upwards housing market. When the housing bubble burst, sub-prime borrowers were the first hit.

So why are these seemingly limited events causing bankruptcy, stock market craziness, and plummeting confidence in the global economy?

Beyond the Housing Market

What could play a bigger and more crucial role in this economic decline is the very nature of Wall Street. Let's look first at how mortgage loans are used in the stock market. A derivative is a financial instrument whose value derives from some underlying asset. Mortgage loans are assets; groups of mortgage loans combined into a tradeable security are derivatives.

Securities are rated by rating agencies: a stellar AAA+ rating, like that given to U.S. Treasury bonds, means that the underlying assets have a very low risk of default. A security whose underlying assets include sub-prime loans would theoretically receive a lower rating. Many investors are told not to invest in the lower rated securities. But what if the rating systems are compromised?

Let's back up. Derivatives are part of a "imaginary" economy of sorts. The "real" economy is made up of people buying and selling goods and services, and going to work at jobs where they make or deliver these goods or services. The other economy is a place where speculators make bets on what will happen in the real economy. Think of it in terms of sports gambling. The real economy is the actual players, the football or basketball or baseball players involved in the actual game. The other side is the folks betting on the outcome, and not just the final score but the point spread, individual players' stats, and more.

Rigging the Game

A safe bet would be that securities based on sub-prime loans would be a risky endeavor, full of potential for default. Investors should stay away, would go the normal logic. But that's good enough for investors hungry for big gains.

Thus arrived the collateralized debt obligation (CDO), which takes a pool of securities based on risky (sub-prime) mortgage loans and divides them up. One part of the security gets a high rating (sold to the cautious or the folks who have investment restrictions), and another gets a low rating (sold to the buyers who don't mind risk). If the underlying assets (the sub-prime loans) are defaulted, the lower rated slice loses money, and the higher rated slice is protected.

These CDOs have been massively popular in recent years. Even the lower rated slices - high risk also means high reward. The demand for these CDOs based on subprime loans became insatiable.

So mortgage lenders were encouraged to continue extending these loans, no matter the risk.

Snowballing

Subprime loans defaulted after the housing market's unreal ascension slowed. They defaulted in so many numbers that the lower rated CDOs caused massive pain to investors. They defaulted in so many numbers that the higher rated CDOs began to lose money. Because these CDOs were so popular and widespread, this meant a big chunk of tradeable securities were now in danger.

But it doesn't stop there. "Regular" hedge funds, pension funds, municipalities and mutual funds might seem protected, but their lack of transparency means no one really knows if CDOs and other dangerous investments make up a significant portion of the portfolio. Companies could rely on the adage that has kept our economy afloat in the past few years - borrow more. It's easy to get and at good rates, right? But now that everyone is feeling the heat, the money is limited.

So subprime loans, though they seem a minor part of the economy, are actually intrically tied in with Wall Street, all other sectors of the national economy, and global economies. It was the first domino in an complex arrangement to fall. Now we just wait to see what happens next.