How Wall Street's Scam Artists Turned Home Mortgages Into Economic WMDs

By Joshua Holland, AlterNet. Posted October 18, 2008.

If the ABCs of the financial meltdown leave your head spinning -- if "default swaps" and "collateralized debt obligations" and "high-rated tranches" are all just so much gobbledygook -- don't worry. You're not alone.

The alphabet soup of exotic investments that represent the immediate cause of the banking mess is so complex that many of those "innovative" financiers responsible for bringing the global economy to the brink of collapse are now making a fortune in consulting fees explaining just what the hell it is that they created. According to the Financial Times, Robert Reoch, the London banker who may be responsible for creating the first of the now-infamous debt-based securities, is now "swamped by investors who want to extricate themselves from derivatives-linked messes, or simply to understand the products that came out of the past few years of intense financial innovation." The Washington Post reported that Joe Cassano, the financial products manager "whose complex investments led to (AIG's) near collapse," is raking in $1 million per month in consulting fees from the ailing financial giant to help sort out the toxic sludge on (and off) the bank's books.

But despite the dense jargon, it's important to get a handle on this stuff. The global economy is at risk of a crash that would cause intense pain among millions of ordinary people, and not because of a few million homeowners overextending themselves, but rather as a result of a small number of savvy wheeler-dealers rigging an unregulated investment market in such a way that they'd always win no matter who else lost.

This is a story that's easily lost in the mumbo-jumbo of market-speak, and the investment banking community -- and its political allies -- have been working feverishly to shift the blame for the mess onto the poor and people of color, Fannie Mae and Freddie Mac -- the large government-backed lenders -- community groups, "Congressional liberals" and even gay people.

Those charges don't even rise to the level of an argument, but that only becomes clear when you have a grasp of what all these "toxic" securities that everyone's talking about really are.

It's certainly true that people got in over their heads during a frenzy of home-buying and refinancing, and it's also true that lawmakers from across the political spectrum have long tried to increase American home ownership -- it's a politically attractive antidote to inequality.

In 2002, George Bush announced an ambitious goal to increase "the number of minority homeowners by at least 5.5 million before the end of the decade," and in 2005, before the house of cards came tumbling down, he said, "I like the idea of home ownership. … What I want is more and more people from all walks of life, including our African-Americans, opening up the door where they live and saying, welcome to my home; welcome to my piece property [sic]."

But the focus on home mortgages misses a crucial point: Through mid-July, banks had written off about $435 billion in bad American mortgages, a drop in the bucket relative to the size of the global economy. There's simply no way that even a major drop in the value of the U.S. housing market could possibly threaten the economic health of most of the planet.

That's where "derivatives" come in. These instruments, which Warren Buffet called "the real Weapons of Mass Destruction," are "worth" about $500 trillion, or roughly 10 times the output of the global economy.

So just what is a derivative? A derivative is a piece of paper that can be bought and sold for real money but isn't attached to a real asset. Its value is simply derived from something tangible -- hence the name. You hear a lot of talk these days about the "real" nuts-and-bolts economy, and derivatives are in essence the exact opposite: They represent an unreal economy, created by financiers in mahogany-paneled office suites in New York and London, and it's this shadow economy that teeters on the edge of collapse today, threatening to bring down much of the real economy with it.

There are all sorts of derivatives. They are essentially bets -- you can bet that a market will go up, or down, or that a particular company will do well or poorly. You can bet on interest rates going up or down, or the value of a country's currency, or you can make more exotic bets about just about anything in the world -- even what the weather will be like at some point in the future.

But the current meltdown was caused by debt-backed securities tied, at some point, to the U.S. housing market. When you buy a home, that's an asset. Presuming you make your monthly payments, the mortgage held by the bank is an asset as well. When a number of mortgages are cut up and bundled together and then sold off as a security, that's a derivative.

Writing in Salon, Andrew Leonard offered a useful metaphor. He suggested that we think of the real economy like a football game, with real flesh-and-blood players running around on a real field, hitting each other and moving a real ball toward a real goal post. All those guys, the field, the equipment -- they're tangible, the same way that an asset like your house is tangible.

There are some people who have a direct stake in the game -- like the teams' owners and the players' families, agents, etc. But there are also millions of people who might bet on the outcome of the game but are in no way directly involved in the play. It's these bets that parallel the trillions of dollars in debt-based derivatives that have become so "toxic" -- they were making some people rich when the housing market was flying, but now that it's tanked, they've turned out to be bad bets, and the amount of money at stake is enormous -- far, far larger than the entire value of the U.S. housing market.

Now, we've also heard a lot about "credit default swaps," "collateralized debt obligations," "structured finance products" and a lot of other finance-speak in recent weeks. Collateralized debt obligations are collections of debt -- any kind of debt, but in this case bundles of mortgages -- that are sliced and diced and sold off to investors. Credit default swaps are like a form of insurance that allows those investors to hedge their bets, in case their guts prove wrong and the debt that they're betting will be repaid turns bad on them.

All these exotic financial vehicles are essentially contracts between two parties -- like bets between two fans -- that lay largely outside of the regulatory system that governs most of the banking sector.

In theory, there's nothing inherently wrong with any of this -- these are tools that allow sophisticated investors to control the amount of risk they're taking on when they plunk down their money to buy into some sort of security. But in practice, these exotic financial instruments have the potential to devastate the world economy. And you don't need an MBA and an intimate understanding of how "obligation acceleration derivatives" work to understand how.

You only need to understand a few central aspects of the huge market in debt-based securities that's grown up over the past three decades. In large part, they exist in a shadowy world free of regulation or oversight, they allow investment bankers to repackage risky investments into something that appears to be relatively safe (or at least safer than they really are), and they allow investors to "leverage" their investments -- essentially buying securities that they don't have the money to purchase -- to a far greater degree than traditional investments allow.

During the 1990s, when interest rates were low around the world, the demand for more exotic "structured" investments -- including various derivatives and swaps -- skyrocketed. And the investment bankers who were structuring these fancy new bets had little to lose in giving investors what they wanted, as long as the housing market -- the hard assets underpinning all this theoretical wealth -- held up.

In order to meet the demand, those financial gurus also put enormous pressure on the lending industry to lower its standards and pump out more and more loans for everything from houses to small businesses to consumers' spending -- the raw materials for the new investment vehicles they were creating out of the ether.

By doing so, speculators in the "unreal" financial economy had an enormous amount of influence over events in the real economy.

Think about that last point. It's the equivalent of people who are gambling on that football game paying off the ref, or bribing a player to fumble the ball on the five-yard line.

See more stories tagged with: housing bubble, financial crisis, toxic securitiees, derivitaves

Joshua Holland is an AlterNet staff writer.

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