Predatory Lending

On one level you have the borrowers who are demanding credit. On the other side of the spectrum, you have cash. Huge amounts of cash flooding into the US from the overseas (but not necessarily). Too much cash looking to fund. There are only so many corporate bonds, credit worthy mortgage borrowers, et al. The cash placement push. Trillions of dollars from overseas.

The cash is available and all the banks are offering this money very, very cheaply. Cash was offered to originating lenders, who in turn employ (affiliate) themselves with brokers. Brokers are supposed to be acting on behalf of the borrowers. The problem is they were only looking after themselves by getting huge fees from originating all these deals.

You'd think that since they were responsible for the loan, they would be picky as to who they were lending to. However, here, we had the secondary market driving the market. Originally, the brokers were liable on a recourse theory. Here, there was insulation. There was a difference between the lending institution and their employees. Management was looking out for the best interest of their financing company.

The mortgages were pooled, and sold to these structured investment vehicles (SIV's) or Special Purpose Entities (SPE's). This SPE would issue bonds. Mortgage backed bonds (CDO's). The problem was the pool was garbage (subprime!). In order to induce the bondholders, the bondholders want good collateral. The rating agencies would then rate these bonds as AAA. They got that through greed. Moody's et al were getting fee's from the bond issuers. If Moody's started to choke and splutter, the bond issuer would go to a different rating agency.

Loan to value ratio. How much will you lend me on the million dollars? Typically 600k. You want it to be conservative.

The bond holders and their underwriters had indentured trustees. The bond holders were people who were really risk aversive, so they wanted insurance. They went to big banks, but they didn't want to insure them. Instead they sold them credit default swaps, on the strength of the AAA rating.

They also hedged their credit default swaps. They would turn to another company and say, if this bond goes into default, will you do a credit default swap. That hedge is cheaper than the actual premium they're getting. They're leveraging. For putting out no money, they get net income out of it b/c the value of the hedge is less than the income to them.

There was a daisy chain of credit default swaps or guaranties.

There were about 7 trillion of these running around and 50 trillion in credit swaps running around. The risk of the default was amplified through all of this.