Understand the Financial Crisis: Part 2

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There are two reasons why this money went into real estate.

The first is that the Federal Reserve pushed interest rates down to a ridiculous level. Many people who were smart enough to realize that such low interest rates were good for investing in real estate did just that. They invested in houses and condos. Convinced that the only way to go was up, the suckers bought with abandon.

I remember driving through the suburbs of Washington DC circa early 2001 and coming across a neighborhood, a tract development, that had a sign in front of it that said “4 bedroom houses from the 1.2 millions”. I remember thinking that any house that could sell for a million bucks should not be in a development.

What was almost equally insane was that I also remember thinking to myself that if I could just afford to buy such a house, I’d make a fortune. Thank God I didn’t qualify.

The reason these houses, which a few years before would have sold for less than half the price were now were selling for over a million dollars was the combination of incredibly easy money created by the Federal Reserve, and the new financial tools the banks had developed to deal with a new way of doing business in real estate.

Banks recognized that many of the new homeowners in the market had little skin in the game. Many of these new homeowners put very little down on their new abode. So, in an effort to spread risk and not put their balance sheets in peril, many mainstream banks decided it was in their interest to “sell” the mortgages they originated to other companies. This moved the loans off of the balance sheet of the bank and to the balance sheet of companies that created Mortgage Backed Securities.

Mortgage Backed Securities were a way for investors to cash in on the hot housing market. They offered very enticing yields that paid out like bonds, often well over 7 or 8% and could be bought in a brokerage account. They were easy to own, and were rated by the ratings agencies as high quality. Why wouldn’t the average investor buy mortgage backed securities? Moody’s, S&P, and Fitch, independent rating agencies, had given their stamp of approval. And real estate only goes up right?

There are many villains in the current economic mess, but one group that is often overlooked by the average observer is the absolutely key roll the rating agencies had in creating the illusion that would soon vanish into the ether. It was the job of rating agencies to give accurate assessments as to the quality of investment vehicles that were hitting the market.

Unfortunately these rating agencies were also paid by the companies that were bringing the mortgage backed securities to market. As such there was a strong incentive for the agencies to turn a blind eye toward numbers that might screw up a AAA rating.

Because they didn’t want to hurt their fee income, the ratings agencies were basically willfully ignorant of facts that would create and bumps in the road to offering.

What was said to be AAA was not AAA. But even the pros didn’t know this. AAA was supposed to be AAA. The ratings agencies were supposed to offer good information, that was their bread and butter. In the early 2000s however the bread and butter came not from their craft but from the ability of the ratings agencies to leverage their long legacy of trust for short term profit.

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