Leave it to Wall Street to make money in new and imaginative ways. Most people, when they think of Wall Street, think about the usual way of making money: buy low, sell high. That relies on a very simple and understandable concept: buy something real like stock, which is a real percentage of ownership in a real company, and when the value goes up, sell out. Derivatives are trickier.
Derivatives are financial contracts whose value is driven by the value of something else which is known as the underlying. The underlying component can be an asset like stock or an index like interest or exchange rates. In a very simple example, lets look at trading stock options. If XYZ company's stock trades at 10.00 and you expect it to go up 50% to $15.00 in the next month, ideally you would like to have the ability, but not the obligation, to buy 100 shares at $12.50 a share. It is easy enough to find someone out there who already has 100 shares of XYZ who would be happy to sell you the option to buy their shares at $12.50 a share. This person already owns 100 shares of XYZ and is not convinced that the stock price is going to appreciate much so they will sell you the option to buy XYZ stock at 12.50 a share anytime within the next month but it's going to cost you say 20 cents a share or $20.00. If the stock stays put, then you have only lost $20.00 (known as the premium) and you never exercise the right to buy the stock. If the stock zooms to $14.50 a share, you immediately buy the person's shares at $12.50 a share and turn right around and sell them on the open market for $14.50. You have just made $200.00. Obviously it's a little more complicated than this but you get the very basic idea.
Wall Street positively excels in tricky ways of making money.
Now that Wall Street was handling a lot of the vast mortgage industry, the questions then became how to make more loans and how to add derivatives to this boom. No loan scheme smacked of more cunning than the loan known as the "Pick a payment" loan technically known as a "pay option negative amortization adjustable rate mortgage". The idea was easy, if you didn't pay all of the payment on interest, then the amount you didn't pay was added to your principal. If you aren't familiar with loan actuarial tables know this: it is normal the first several years of your loan that the majority of your payments are applied to interest and not principal. Not paying a complete payment every month made your loan get very expensive, very fast. The lure of picking your own payment was very popular among the very people who didn't possess the financial means to buy a home anyway. The payments went down but the interest went up: WAY UP. Homeowners were never paying down, only up.
Wall Street had tons of mortgages with homeowners obligated to send their monthly mortgage payments straight to the banks. It was a steady and certain stream of income and now the question became how banks would securitize this stream.
The answer was Collateralized Debt Obligations or CDOs, a new security that was derived from slicing and dicing mortgages.
It was a new security, but how could banks succeed in selling them? Easy, the ratings agencies.
Moody's, Standard and Poors and Fitch were founded originally as a way to protect investors by rating securities. Somewhere along the way, arguably, they became an advocate of the very companies they were supposed to rate.
When rating a security here's the scale from top to bottom..
Obligations rated Aaa are judged to be of the highest quality, with the "smallest degree of risk".
Obligations rated Aa are judged to be of high quality and are subject to very low credit risk, but "their susceptibility to long-term risks appears somewhat greater".
Obligations rated A are considered upper-medium grade and are subject to low credit risk, but that have elements "present that suggest a susceptibility to impairment over the long term".
Obligations rated Baa are subject to moderate credit risk. They are considered medium-grade and as such "protective elements may be lacking or may be characteristically unreliable".
The levels above are termed as "investment grade". The next level down is "speculative grade", better known as high yield or junk. The key to selling CDOs was to get the ratings agencies to rate CDOs as "AAA". This complicit role was one that the rating agencies were happy to play.
This was a clear betrayal of what the ratings agencies were originally set up to do. Ratings agencies are responsible for advising pension funds, non profits and other big institutional investors on what securities to invest in. By mandate, most institutional investors are required to trust only investment grade securities. Big investors now had no honest advocate in the ratings agencies.
Harsh assessment? No, not at all considering that ratings agencies were now being paid by banks to rate these investments as investment grade instruments. Also, by not rating these instruments as investment grade, the ratings agencies risked losing the opportunity of doing business with these banks later.
Ratings agencies stocks went up and cash came rolling in.
What exactly are CDOs? Individual mortages are pooled together to create a mortgage backed security. Banks then take selected parts of those MBSs, package them together and you have a CDO.
Housing prices were going up, up, up and these securities were little pieces of those mortgages.
A terrifically bad mortgage system was now terrifically securitized and this was only the beginning. Now these securities had to be sold.