> Congress pushed the banks into doing them in the early 2000s to extend credit to marginalized populations!
...but didn't push banks to lever the loans 10x, securitize, sell and repeat over and over again. Fault for those days lied in a lot of places, and sub-prime mortgages aren't inherently a bad thing.
> and sub-prime mortgages aren't inherently a bad thing.
Correct.
> ...but didn't push banks to lever the loans 10x, securitize, sell and repeat over and over again.
Yeah, but I'm not going to pretend like I wouldn't. Worst case scenario is that my failed bets get paid out by the future productivity of the entire working population, and the distressed assets get transferred to the balance sheets of special purpose vehicles also funded by taxpayers.
The way markets work is that there is a certain opportunity work $X based on the actual (not idealized) consequences of setting up a series of transactions. If incentives are such that there is a market opportunity worth $600B by selling subprime mortgages and socializing the risks, then eventually somebody is going to capitalize on that market opportunity, regardless of how immoral it is. If only one person does it, they make $600B. If 10,000 people do it, they each make $60M, modulo inequality within the market. The only thing that being moral gets you - other than warm fuzzies, which unfortunately you cannot eat - is larger wealth inequality that happens to benefit the person who is most immoral. (In fact, I wonder if one of the other drivers of inequality today is that by-and-large, most Americans are nice, decent, moral, hardworking people, which means that the market opportunities available to scumbags are only capitalized on by a tiny minority.)
The only way to avoid immoral behavior is to fix the incentives so that it doesn't pay off. In this situation, that means either make it uneconomical to sell (perhaps by penalties like jail time), or to not allow the sellers to socialize the risks (perhaps by not bailing them out when they failed). The former means that low-income borrowers can't buy homes; the latter means that the financial system would've imploded. Personally I think Obama would've been better off taking the latter course and letting the banks fail, but the point is TANSTAAFL and whichever course you to take will require some sacrifices, whether in equality, stability, or trust.
A lot of subprime issues from 2000 had to with diligence on the originator. There was widespread fraud on income, and employment reporting to meet the demand for CDOs and other mortgage-backed securities. Subprime has its place to loan out money to people who have the capability of repaying the loan but might not have the credit history/score to get a standard loan.
This is a mantra repeated by everyone who is not business of making loans.
There's enormous competition for people with capabilities of repaying a loan but no thin credit files/scores. Those are credit scores between 575 and 650. There are government programs that target these people administered via Freddie, Fannie and FHA for automatic underwriting. Those are done? No matter, USDA(!) would guarantee loans in rural areas! Banks themselves do manual underwriting for people who barely qualify or on a cusp of qualifying at prime + rates. Those were not the subprime loan customers.
Subprime loans were originated with the same rationality as the loans covering Buy Here, Pay Here car loans: they were originated with a total knowledge that the buyer will fail to make payments and will be foreclosed on - no matter! Buyer would make payments for first 6-7 months, default, get foreclosed on and the house would be sold to someone else for higher amount than the defaulted loan. Housing was an appreciating asset when these loans worked fine on depreciating assets ( cars ).
Structural inequality or not, people who have shitty jobs and shitty financial position typically make shitty financial decisions over the long term. 30 year mortgage is a very long term financial play.
Perhaps I am misunderstanding your point, but that still sounds like a fundamental problem with the originator.
If you are lending money with the unspoken understanding that the note is likely doomed to be a loss unless the real estate market continues to go up, then you are not really in the loan business anymore. You are putting letting your capital ride on the real estate roulette wheel, while enjoying the fat fees in the short term. The fact their were enough greater fools around to move your capital from new bad loans to newer bad loans may let you bank a few more fees, but it still means the originator is choosing to screw up while hoping to be rescued by real estate market forces completely beyond his control.
> 7% of delinquencies was enough to crash the global economy
The delinquencies ended up being less of a problem than the uncertainty around them. 7% delinquencies didn't kill anyone. Investors' fears that 7 would become 20 did.
The way that securitization works is that you take many thin streams of cash from individual loans, and bundle them into a giant river of money. That river will dry up at some point, and what point depends on how much defaulting there is. You then take horizontal chunks out of that river and sell them off. The first few slices are low risk - they will pay off even if lots of people default. The last one is very high risk indeed and are only worth pennies on the dollar, if that.
The principle is that it is safe not because it is bundled with better debt, but because those bonds still pay even if lots of people default. They may pay late, but they should pay.
However the models quantifying the risk assumed that there was a lot less correlation in defaults than there actually was. So when the housing market moved against the loans at the same time as people lost jobs in the financial crisis, investments that were supposed to be safe suddenly weren't.
I could believe 7% as the losses in bonds that originated as AAA bonds. But not as the losses in AAA bonds.
That’s right, but perhaps I can give a stab at a more technical explanation.
An RMBS is a portfolio of mortgages financed by multiple bonds, with an order of subordination between them. When a loss occurs on a mortgage, it is allocated to the most junior bond first, until it is fully written down, then the next junior bond, etc. So if you own the most senior bond (often rated AAA), you are really exposed to high default rates and high correlation. Ie if the portfolio of mortgages is diversified (low correlation) some mortages will default but not all at the same time, and there will always be enough mortgages that do not default to avoid a loss on the most senior bonds.
The big fuck up in the financial crisis is that the correlation was misestimated. There had never been a large, US wide, real estate crisis since 1929 and therefore everyone assumed a US wide portfolio was well diversified. That turned out to be wrong in 2006-2007, and delinquencies (ie balances of loans not paying interest or principal) shot up. This led to losses (not 100% of a defaulted loan, the house still had some residual value) that ultimately hit the AAA bonds.
A CDO is the same structure but using bonds in the portfolio instead of residential mortgages. But when people refer to large losses on CDOs in the financial crisis they usually refer to CDO of ABS, which basically uses junior RMBS bonds in the portfolio, so effectively you leverage the mortgages twice, first through an RMBS, and then another time through a CDO.
In those you are even more exposed to correlation. The portfolio is made up of junior RMBS bonds from multiple RMBS transactions originated by multiple subprime lenders across the country, so these structures were playing on not all of these RMBS going bad simultaneously, which is exactly what happened.
So the TL DR is that these portfolio of subprime mortgages and RMBS bonds were of a similar credit quality, but correlation is what got really badly mispriced, they were assumed to be diversified but what we got is a large US wide real estate crisis that hit everybody,
...but didn't push banks to lever the loans 10x, securitize, sell and repeat over and over again. Fault for those days lied in a lot of places, and sub-prime mortgages aren't inherently a bad thing.