THE WORLD OF FINANCIAL PRODUCTS: HOW TO TURN LONG TERM GREED INTO A SHORT TERM DISASTER

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THE WORLD OF FINANCIAL PRODUCTS: HOW TO TURN LONG TERM GREED INTO A SHORT TERM DISASTER

If you ever spend time with a politically energized group you’ll probably notice that they argue. Actually, that's an understatement: they argue all the time. The finger pointing never stops. Half the country seems to blame the current president for our economic despair, while the other half seems to blame the FORMER president. This non-stop parade of partisan identity is truly frustrating to the few who actually knew the source of the financial collapse of 2008. What’s most frustrating is that the source of the problem has enough blame to spread around to both the Democrats AND Republicans. This is a thoroughly bi-partisan problem, and I’m about to explain why EVERYONE is wrong.

Last week we talked about the financial industry and its history. With a newly de-regulated market, the world of financial innovation was at an all time high. The firms that ran this industry were fewer in number and doubled in size. We had a few major commercial banks, a handful of investment banks, two insurance companies, and three ratings agencies. All of these worked together to make the financial industry as profitable as possible. And the system they had worked out to help keep the new system alive: securitization.

Securitization is the new way America makes payments. In the old days you would barrow money from your local lender and pay that lender back directly. This is precisely why we wouldn’t give loans to just anyone. The people who lent the money were very meticulous and watched that money very closely. They had to: if they didn’t, the loan could default and they could lose all their hard-earned cash. With a direct-payer system we knew what was at stake.

In the now, the payment system works like this: we accept a loan and make payments to our lender. However, unlike the days of old, now the lender can sell our payments off to investors around the world. They did this buy lumping the payments of several debts together to create a much higher sum of money. They don't lump the amount they actually have on hand: they lump the TOTAL value of the loan before it even matures. So if you have one hundred $100,000 loans that have not received payments yet, they still think of this loan money as ten million dollars. Then they sell a piece of this ten million dollar pot to the investors who are willing to buy them. These financial products are called derivatives (they derive from payments), and they became VERY popular in the new millennium. The particular derivative I’m talking about here is called a Collateralized Debt Obligation (or CDO for short.) A CDO can consist of credit card debts, student loans, and mortgages. You can buy these products from investment banks like Goldman Sachs or J.P Morgan.

This was step one: take payments, lump them together, and sell the resulting product off to people for their investments portfolio. But it’s still the same amount of money, only dressed up for mass consumption. So the banks decided they needed to take this game one step further. They needed a way to make people believe in the same magical thinking that they were deeply invested in: that somehow these lump sum debt amounts were more valuable than a single mortgage. Even though the mortgages haven’t actually been paid off yet, the financial firm can make claims to its future worth.  So they can say that the financial product you paid $100 million for will actually be worth $200 million in 10 years after the mortgage matures. It’s a kick-the-can-down-the-road kind of thinking, but a lot of people bought into it.

Not only can you lump mortgages and not only can your firm claim that when these mortgages mature that they’ll be worth twice as much, but you also have ratings agencies that will verify that this financial product is actually a solid investment. Moodys, Standards and Poor, and Fitch were all the main players in this part of the financial charade. They evaluated literally billions of dollars to give the investment grades. These grades were rated as follows: AAA is the highest rating, and then there’s CCC at the bottom (known quite literally as a “junk” investment.) The financial products that had the best rate of return were usually the ones that yielded the least amount of money in the short term because it was a less risky investment. The “junk” investments, however, had high yields because they were much riskier.

But why would they want to do this? Doesn't this just make payments and debt more complicated? Well, yes it does. But it also solves two problems: first, you don't have to wait for a mortgage to mature. You can sell a financial product as if it has been paid off and receive a large sum of money RIGHT AWAY. You can also make bad deals and sell those bad deals to other people, stamping it with Moody's coveted AAA rating. Now you have the money for these house payments right away, and when they go bad it's now someone else's problem.

This magical thinking was the perfect trap for the future of our financial security. The cookie jar was opened wide, and most of the major financial firms saw the chance to manipulate the system. Here’s how they did it:

First, they thought it profitable to create as many mortgages as humanly possible so they’d have plenty of expensive financial products (CDOs) to sell to customers. The yield on these mortgages is now instantaneous because you’ve sold the risk off to someone else, and that same customer paid for several mortgages in one go.

They also made it insanely easy to GET a mortgage.  The old days of actually having to qualify for a home was all over: now, with a shady lending technique called “sub-prime” lending, lenders could sell a mortgage to a family with no money because the family didn’t have to have any equity in the house. They didn’t have to put that much money into it all, sometimes paying less than 3% on the total value of the house. So all they had to do was make payments based on the market value of the home. And if they couldn’t pay, they’d just re-posses the house. But who cares if the mortgage went bad? It’s now on someone else’s books.

But how did they convince investors that these CDOs were actually valuable investments and not just crapshoots involving mortgage payments from people who lived in houses they couldn’t afford? Fortunately for the banking industry, there was one more thing up for sale: the opinions of the ratings agencies. Moodys, in particular, was a huge pawn in this scheme. With enough money, the financial firms were able to buy favorable opinions about the financial products they were selling. Many terrible investments were now given the highest possible rating, rated as high as government securities.

To sum these complex ideas up: payments are no longer given to just the banks. The banks take payments and lump them together to sell off as “securities” to investors. Then they make a long term loan instant cash. This is so profitable that they start making mortgages widely available so they can create more securities to sell off to investors. But the only way they can sell as many houses as they need is to increase their sub-prime lending, where the borrower has basically no money in the house. And to hide this fact that they were selling off terrible mortgages, they paid the ratings agencies to give the securities comprise of crap mortages the highest possible rating.

If you can already see where this trail is leading, be prepared: the results were much more fantasical and much worse than ANY of us could have imagined…