QuickOverview

The Sub-Prime mortgage crisis in the U.S. is often blamed for the "Great Recession" the United States sunk into starting in late 2008. I was a little bit of an insider in that I worked for a Mortgage bank that routinely funded $3 Billion of risky loans every month and instantly went out of business when the crisis struck. I managed a technology team and was a bit removed from the financial operations of the company, but I saw enough to draw my own conclusions of how the crisis happened and who was to blame. I decided to write this article anonymously so I could be free to speak honestly about the operations of my company and former colleagues without publicly identifying either.

Demand for Borrowers Created by Investors

Most large mortgage brokers and mortgage banks made money by selling loans they funded as quickly as possible for small profits and immediately lending the money again to the next borrower. Most of the loans we funded were sold to Fannie Mae, Freddie Mac, giant banks, or large Wall Street Brokerages within a few days. These investors who purchased loans created financial instruments called mortgage backed securities that combined their loans and were very popular with their own customers. These end customers often were pension funds, foreign governments, and private equity funds who had large amounts to invest and were attracted to the high returns of these investment products for seemingly low risk. The more demand these investors had for their mortgage backed securities, the more loans they wanted to buy, and the more creative the mortgage banks had to be in finding customers to buy new houses and refinance. In addition, since investors were making a lot of money off these mortgage backed securities, they became increasingly willing to buy loans to less qualified borrowers.

Liar Loans

As demand rose for borrowers, the mortgage banks came up with the idea to lend loans known as Liar Loans, which were generally of sub-prime quality. Naturally, they referred to these loans with a nicer name, such as "Alt-A", which were meant to give the meaning of "Alternative to A paper, but almost as safe."

Basically, the banks did not verify the income or assets of the borrowers. When I went to an underwriting class given by my bank, I asked "What is the reasoning for this?" I was told that it is targeted for professionals such as writers and independent contractors. Those types of professions sometimes earn high incomes, however, the income is not consistent and is difficult to document.

The reasoning for this type of loan made some sense as long as the investors in these loans understood the risk, but they didn't. In addition, the products were abused in several manners:

• Unscrupulous mortgage brokers convinced naive borrowers to inflate their incomes to qualify to buy houses that they coulnd't afford.
• Uninformed borrowers thought they could afford houses because the initial payments were low and didn't realize that the mortgage payments would rise once the introductory teaser rates expired or global interest rates increased.
• Aggressive borrowers speculated the property prices would rise so they could keep refinancing and "flipping" their houses for profit after holding them for a short time.

Credit Default Swaps and Credit Rating Agencies

As increased investor demand encouraged riskier and riskier borrowing, the investors should have taken the higher risk into account. However, that never happened because the mortgage backed securities all carried high investment ratings from respected ratings companies like Moody's and Standard and Poor's.

How could these increasingly risky mortgage backed securities get rated as safe investments by established ratings companies? This had to do with credit default swaps. These were insurance policies that were in place to counter the cost of the borrowers of risky loans not meeting their loan obligations and having their houses foreclosed. The problem is that these credit default swap insurance policies, sold by companies such as AIG, were priced based on very complex mathematical calculations that had the assumption that real estate prices would keep rising. Once real estate prices stalled, the underwriters of the credit default swaps could not meet their obligations, which sunk the mortgage back security values, and dried up funds available for real estate loans.

Who is to Blame?

If you ask 100 people who is to blame for the sub prime mortgage crisis, you might get 100 different answers. Here is my opinion, in order of culpability:

• Ratings agencies that didn't understand the models underlying credit default swaps and certified those mortgage backed securities as safe.
• Executives and board members of AIG and other issuers of credit default swaps. It is their job to manage risk, but they did not. Instead they focused on short term profits and bonuses and left the shareholders responsible for the inappropriate risks they entered the corporation into.
• Executives and board members of Wall Street firms that peddled risky investments as safe. They also focused on short term profits and bonuses and did not fulfill their duty to shareholders.
• Government regulators whose job is to observe the business practices of these mega corporations. They did not.
• Some of the borrowers that entered into sub-prime products and got in trouble, but only the ones who understood the risk they were taking.

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