Fueling the Flames of Debt
by Part one of a series that describes the path to economic Armageddon. Written as a plain language explanation of current economic conditions.
Here is a simplified example of how this was done;
A big bank makes a thousand mortgage loans. In its quest for a fatter quarterly report it makes these loans to sub-prime borrowers based on hyper inflated property values. The borrowers, being unqualified for the loan under any reasonable criteria, pay nothing down and a low interest rate at first. The mortgage is based on property values that are inflated by the fact of the availability of sub-prime financing. This financing creates more buyers that bid up property prices, which in turn inflates the property values.
These debts are then bundled together into a CDO and offered to investors as investment grade instruments. The investor has no reasonable way to assess the quality of a thousand borrowers and a thousand properties. It simply cannot be done without a huge investment of time and money, which would negate any benefit from the investment.
So the investor relies on the assessment of a ratings agency. Making qualitative assessments of bonds is what they do, rating a particular instrument on a scale based on quality, the likelihood of the obligation being met, and the value of the underlying property that backs the debt. Now we have a new layer of uncertainty. The ratings agencies have no reasonable means of assessing a thousand borrowers and a thousand properties either. So how do the ratings agencies rate the issues, you ask? Simple. They ask the bank that is offering the CDO. The smell of rat is becoming noticeable at this point.
The rat, errr, I mean bank, doesnt just send the ratings agency the paperwork on each loan and allow them to assess individual qualifications of the borrowers. First off, this would be a huge logistical burden on both the agency and the bank. Second, doing so would violate several state and federal privacy laws.
The bank gives the ratings agency a sanitized version of the bundled debts and a current value of the underlying property. Both are based on highly inflated property values and federally mandated mortgage credit rules. The ratings agency then ranks the CDO based on the banks own assessment. The final step in the ratings process is when the bank sends the check to the ratings agency. Oh, did I neglect to mention that the ratings agencies work for the banks, not the investors?
The smell of rat is quite pungent by this point, and the situation begins to escalate exponentialy as even more obscure derivitive instruments are developed from the CDO mess. That is a subject for another time.
Good Luck
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