How did the global economic collapse occur? It built up over a few years and involved a perfect storm of greed, lack of oversight and the creation of new derivatives. Circulation of money is what makes the economy work. That circulation is credit.
Post 9/11 we had something of a problem in the US, specifically the economy was in trouble. Alan Greenspan cut interest rates to stimulate growth and ultimately the cost of borrowing money was extremely cheap; cheaper than it had been in decades. Housing prices began to rise faster than incomes creating a grossly overpriced housing market.
How then do you get people into new homes? Easy, by loosening lending requirements and extending credit to those people who would become known as sub-prime borrowers (FICO score below 500).
This was a wide departure from the way that lending used to be done. Your income had to be fully documented with lenders even going as far as coming to visit you at your workplace. The loan process typically would take a few months. Every detail about you as a borrower was scrutinized.
After the bank said yes to your home loan, the path to your loan led to Fannie Mae and Freddie Mac: government sponsored enterprises (GSE) whose job was to buy the loan from your bank, give the money to the bank so the bank can turn around make more loans.
The GSEs received a steady and constant monthly income from these loans. The GSEs would then take the money flowing in from these mortgages and place them into a pool and sell shares into the pool. These investments were known as Mortgage Backed Securities. They were big money and they were bought by big entities like pension funds.
The GSEs for a very long time dominated the multi-trillion dollar mortgage industry and because of that, the GSEs were able to dictate the terms of the mortgages that they would buy. Obviously they wanted people who were able to pay back their loans and this strict behavior kept lending risk to a minimum. Having strict lending requirements was necessary to insure the integrity of the mortgage backed securities.
This policy also kept many people from buying homes because of lousy credit or lack of a down payment.
Fannie Mae and Freddie Mac faltered due to accounting scandals and their dominance suffered as a result. This was great news to many mortgage originators. The GSEs insistence on strict guidelines didn't allow mortgage originators to make as many loans as they wished and they searched and got alternatives to the GSEs. Specifically these alternatives were underwriters like Countrywide Financial which in 2006 accounted for 20% of all mortgages that were underwritten in the U.S..
The deep pockets of the GSEs was being replaced by the deep pockets of an unregulated Wall Street. The dynamic had changed.
The world itself had lots of cash and had no idea what to do with it. China and India were flush with cash as were countries in the Middle East that produced oil. What were these places going to do with all this cash? Invest it in Wall Street! Wall Street had securities that were backed by the American housing market and by American borrowers. Questionable securities were born.
Julian Cook/March 5