Festering Junk and the Law of the Few

I always thought it was a bit too simplistic to say that "greed" was one of the major causes of the massive, subprime financial failure, but the more I read about it ... it is apparent that greedy folk are abound on this planet. (And I don't mean greed as it applies to achievement. To me these are diametrically opposite beasts.) One article I read details the speech of a banker admitting that free checking is a "tax on poor people" because they, the bank's, counted on collecting fees through overdrafts and add-ons.

The sub-prime mortgage market allowed investors to tap into the largest asset base in the states, the home, and although one of the supposed key tenets was to allow home-owners to tap into cheaper interest money, it was like handing a loaded gun to a four-year old.

And then you enter the genius and stupidity of Wall Street. The genius side of the coin (which could arguably still be placed on the stupid side of the coin) came from the folks who invented the subprime mortgage tranches, credit default swaps and the "geniuses" at Goldman Sachs who came up with the CDOs. My understanding is that the tranches and CDOs were ways to hide the junk, B- mortgages mixed in with the not so blatantly, festering junk. The bond tranches were set up like a parking garage (house of cards or stack of dominoes, your pick) with the riskier, substandard loans on the bottom and the better ones on top. The folks on the bottom received the highest interest rates but got wiped out first. Yayyy.

Enter the Genius of Goldman Sachs.

To further mask just how crappy these bonds were, Goldman Sachs started using the CDO or collateralized debt obligation which is essentially subprime bond towers (tranches) within a tower ... or in other words and even bigger house of cards.(stack of dominoe’s etc.)

At this point I would argue that the financial world might not have been devastated by a nuclear bomb had things stopped here but ...

Enter the Genius of Those Who Caught On ...

At this point if you were privy enough to realize just how big the subprime market was ...

“Thirty billion dollars was a big year for subprime lending in the mid 1990s. In 2000 there had been $130 billion in subprime mortgage lending and 55 billion dollars’ worth of those loans had been repackaged as mortgage bonds. In 2005 there would be $625 billion in subprime mortgage loans, $507 bilion of which found its way into mortgage bonds. Half a trillion dollars in subprime mortgage - backed bonds in a single year.” - Lewis, p 23.

And where it was headed, you might just start betting against the subprime mortgage market.

Enter the Credit Default Swap

A credit default swap is essentially insurance on a mortgage bond, insuring against default. The trick is, banks weren't buying them, they were selling them! The individual holding the default swap stood to gain massively if the subprime mortgage market imploded in on itself. Selling a default swap just meant extra income via the insurance premium to the seller.

Enter the Stupidity of AIG

AIG, through the wrangling and tactics of Golman Sachs began selling these things by the bucketfuls and by bucketfuls I mean billion dollar buckets. AIG was taking the other side of the bet and as long as the bank that held the original bond did not collapse, the person who bought credit default swaps stood to gain massively.

I would argue that a few key individuals truly turned a financial crisis into a global thermal nuclear financial meltdown. Had the credit default swap market not have taken off (e.g. those that wanted to buy essentially built the market by talking the banks into building and selling credit default swaps) and the insurers (AIG) not been so blind as to sell these things, I doubt we would still be experiencing the implosion of the housing market today.

In keeping with Malcolm Gladwell's proposition of the "Law of the Few" in which "the success of any kind of social epidemic is heavily dependent on the involvement of people with a particular and rare set of social gifts,"¹ as detailed in The Tipping Point, I would argue that the exacerbation of the financial crisis was caused by a few key individuals.

1.Gladwell, p 33.