Hi there.
Except for the last two statements of yours, which is opinion, and that's fine, much of what you say is essentially true.
And sorry if I come across as an 'expert,' because I am not. But I have had enough economics at the university to be a bit more than conversant as to how markets work, and the most important aspect of properly functioning markets is sufficient regulation, not to make things fair in a moral sense, but in the 'rules of the game' sense, so as to keep things from running amok. The more ethical considerations are handled by the consumer protection folks. I remember the big tustle with Standard and Poor's and the Georgia legislature, and I was amazed at what happened, wondering why somebody wasn't arrested under the RICO act for thuggery. So I got more interested in the details of the subprime thing.
Various parts of the Glass-Stegall act and the Bank Holding Company act had been gradually eased or repealed in the 80's and 90's. These prevented retail banks, investment banks, and insurance companies from combining, so as to protect depositor's funds, paid-in insurance premiums, etc. from being exposed to the greater speculative risks that investment banks engaged in. Banks were prohibited from and insurance companies naturally disinclined towards these more speculative ventures, but, if an investment bank were to buy a bank or insurance company, then they'd just consider those deposits and premiums as a cheap source of funds to have fun with. This was all learned from experience in the 20's.
The Financial Services Modernization Act Of 1999 was then passed, which removed the most prohibitive parts of Glass-Stegall and the holding company act.
Once that happened, the usual cross-sector market forces in which loan originators, banks, and secondary mortgage markets checked each other as to loan quality, thus limiting the risk to reasonable levels, soon melted away. The investment banks could spread the risk of a relatively few low quality loans amongst mostly higher quality loans, package it as a collateralized debt obligation, hire a credit rating agency to rate it, and then sell it to investors, including some banks, mutual funds, retirement funds, etc. The few lower quality loans had higher interest rates, and so made the overall CDO have a somewhat higher return than an all AAA bundle. At first this was done in a fairly safe way, the statistical laws of risk spreading being well tested, and it being fairly predictable the number of actual defaults, after which the total return still made it worthwhile.
But the inherent moral hazard of having an interest in selling more CDO's if the return were more attractive, and at the same time having easy access to the original loans, made it inevitable that lower quality loan originations were actually sought after, then outright promoted, because they had higher interest rates, thus making for higher return CDO's, which meant lots more CDO's sold. This off the top of my head, but subprime loans were ~ 5 % of originations in 2000, then 20 % by 2006.
This increase was obtained by changing the usual practice of charging higher interest on the loan from the outset, which limited the number of people wanting them, to then starting with a teaser rate of 2-3 %, the terms then changing after ~ 3 years which almost doubled the payment. Built-in guaranteed eventual high default rate, right there, but the CDO business was too lucrative for anybody to care. When these mortgage originators started hitting on older, poorer home owners with subprime re-finance or even second mortgages, selling them on the initial lowering of their payments, but easily hiding the fine print from them, then states tried to take action with so-called predatory lending laws, but as I pointed out in the earlier post, the investment bankers sicked Standard and Poor's on them to set them straight.
Standard and Poor's, Fitch, and Moody's all willingly and knowingly rated these CDO's as AAA or equivalents, as the subprime content kept increasing. They took money from Goldman & others to rate these investments, in competition with each other.
To make all this even more fun, AIG and others started taking premiums from investors wanting to hedge against default of these CDO's, largely at the invitation of the investment banks, who got fees for bringing the credit default swappers together. But a huge lot of those obtaining these default swaps didn't even own the underlying CDO's, which bothered AIG not in the least, just give us a few million a year in premiums, thank you very much. Which means that these 'naked' swap buyers were paying the premiums ONLY in anticipation of the CDO's going bad and, guess what? Goldman invited these non-owners to get in on the selection of loans that made up the CDO's, so as to allow them to load these dice to their heart's content. Fees, fees, and more fees, at every step and turn. This is like me taking out fire insurance on a house that you are having built but, unbeknownst to you, the builder is letting me choose the materials for your house, and I toss as much flammable material as I think I can get away with into the truck, while the building inspector stamps "Flame Resistant" (AAA) all over it.
Now, housing bubbles come and go, and no argument from anyone that that is what happened here too. But prior to 1999 there is NO way that a housing bubble of relatively normal size could have had anywhere near this grossly inordinate percentage of defaults. No how, no way.
With the old mechanisms and standards in place, not government mandated but set by what retail banks would tolerate, this bubble, no worse by itself than others we've had not too long ago, would have caused some defaults, some people would have lost homes, some banks would have lost money, a few of them not surviving.
With this new game now being played, defaults were far out of proportion to the bubble itself due to the proliferation of subprime loans, the rating agencies changed their CDO ratings from AAA to junk bond status in less than 3 days, the credit default swap triggers were pulled, AIG now owed half a gazzillion dollars to a bunch of people who didn't even own what they paid AIG to insure, a bunch of retirement funds said "wha ... ? ," bank's assets dropped way way down, right now, and since they knew all other banks assets dropped way down, nobody would give any money to anybody. Meltdown.
With much of the above, change one or two of the names, change the figures some, multiply by a few hundred, and that would explain part of it.
