Explaining the Credit Crisis: Act II

So, we have this massive pool of highly liquid global capital looking for a place to land that offers a fairly safe investment with a modest yield. At the same time US Treasuries, that would normally be a first-choice option, are offering almost no return. Now comes the innovation in securities known as MBSs and CDOs. These were attractive because they offered a relatively high yield, had a steady stream of income - payments to the mortgages - and were backed by an asset that almost never, ever lost value: US houses.

How to turn US mortgages into marketable securities? Here is how it was done: take a bunch of residential mortgages and bundle them together (using a Special Purpose Vehicle but never mind that) and then slice them up into 'tranches.' Tranches are slices that form a queue: the lowest slices get paid last and the highest ones get paid first. Thus the highest ones are the safest and the lowest ones are the riskiest. The slide below presents a nice picture of the process. Because of the different levels of risk these tranches also offer different yields - higher for the more risky ones. This fist step is the Mortgage Backed Security (MBS). There was another step though, because of the appetite for the yields that especially the mid-level tranches (the ones that were investment grade but still high yield) Collateralized Debt Obligations (CDO) were created by taking a bunch of tranches from these MBSs and slicing them up again and selling shares in these securities that were based on securities that were based on mortgages.

Again these were turned in to a queue of tranches where the senior (AAA rated) and super-senior tranches were thought to be almost completely safe - they were the first to be paid off and based on mortgages which had historically low default rates. The ratings for these tranches came from ratings agencies (Moody's, Standard and Poor's and Fitch) which rated them based on past experience with mortgages and their models showed very good performance of the residential mortgage market.

All the while the appetite for these CDOs from this enormous global pile of money was relentless. Not only did this strong demand have the effect of pushing mortgage writers to create more supply by pushing further into the sub-prime market by lowering standards, but sub-prime mortgages were particularly attractive because of the higher yields that they provided (part of the sub-prime deal was higher interest rates).

Also, the really high demand was in the mid-level tranches of the CDOs, so many banks kept a lot of the AAA rated senior and super-senior tranches on their books. And even though they were thought to be very low risk they went to monoline insurers to insure these securities.

But all of this credit being thrown at the home market was fueling rampant speculation and the fundamentals were off: home prices were rising rapidly during a time of stagnant wage growth.

Then the bubble popped...

Suddenly the 'old rules' didn't apply to mortgage defaults. People started to get upside-down on their mortgages, people who bought speculative investment properties just walked away and default rates soared to astronomical - and more importantly - heretofore unheard of levels. This then spurred the real heart of the crisis: the senior and super-senior, AAA and above, rated tranches started to falter and these were on everyone's books. What's worse since the old risk models were suddenly obsolete, no one knew how to price these assets, so no one knew how bad the bank's balance sheets were. Suddenly no one wanted to lend to other banks again and credit seized. The monoline insurers that were on the hook for these senior and super-senior tranches were also taking a bath.

When the internal credit market stops functioning this spills over to other areas as well. For example, student loans are now harder to secure. So this seizing of credit began to threaten the entire credit industry and since credit is the life blood of commerce, we stood on the precipice of a major economic meltdown.

The Federal Reserve, charged with stabilizing the macro economy was facing a major test...