nobody will understand what's going on bc it takes too long to explain...

• ppl purchase homes using 20% of their own money (down pmt) and 80% from a loan (mortgage)
• your local bank provides mortgages of all sizes to many ppl in your town
• if the local property market were to tank, your local bank could suffer serious losses bc all of its loans are concentrated among local home owners - problem
• solution!  the local bank sells the loans to govt sponsored entities (GSEs) called fannie mae and freddie mac while keeping the up-front financing fees you paid when the loan was made
  
  • though you still send your monthly payments to your local bank, the local bank then passes the payments on to the new holder of your mortgage, the GSEs
  • since the GSEs purchase mortgages from your local bank and others around the country, the GSEs have a geographically diversified pool of loans... much safer and, theoretically, everybody wins
    
  • congress provides a guarantee that it will financially support GSEs in tough times.  in exchange, congress gets to influence GSE behavior
• pres bush decides home ownership will help promote family values and is good for america, pushes GSEs to buy more mortgages from local banks.  this makes it easier for local banks to make loans and dump them off on the GSEs (red flag)
  
• property values rise and dems in congress like barney frank think the little guy is being left behind, push the GSEs to specifically buy mortgages made to working class joe sixpacks who couldn't get loans before (subprime borrowers) - how noble!
  
  • local banks will now give mortgages to joe sixpack, knowing they can easily sell/unload these crap mortgages onto the GSEs.  local banks are making loans to ppl but are no longer at risk if the loans go bad, since the GSEs have purchased them.  local banks have an incentive to start making loans to anybody and everybody and lending standard start become lax (we needed regulation at this point in the system).
    
  • hooray!  now, joe sixpack the municipal bus driver making $35k a year can qualify for a $700k loan, what a country.  congress pats itself on the back
    
• GSEs have bought so many mortgages that they run out of cash to continue buying mortgages.  so they sell off the mortgages they purchased to other, private investors like pensions and hedge funds.  they do this by having wall st firms package the mortgages into bonds (securitization), which wall st a) sells to investors around the world, and b) holds in inventory for future sales to investors. 
  
• side note - nobody has ever provided mortgages to joe sixpack before, so banks and GSEs and PhDs working at wall st firms have to guess at default rates and potential losses.  the wall st firms selling the bonds and the pensions and hedge funds buying these bonds are so far removed from the situation that they don't understand that the loans consist of $700k mortgages made to joe busdriver.  they all hate stochastic calc and figure the PhD guys have figured it out.  *stupidity, not corruption or greed.  this can't be regulated so easily.
  
• unfortunately, my former firm was perenially the #1 or #2 firm at doing this.  ddoh!  the firm i work for now was the other firm ranked #1 or #2 at doing this.  ddoh, i'm really good at finding trouble and job insecurity.
  
• the housing mkt cools and ppl who thought they could flip homes at a profit find they are flipping homes for a loss!  in fact, they can no longer sell their speculative investments for enough to pay back the mortgage.  mortgages start defaulting like crazy (much higher than their initial guesstimates) and local banks, GSEs and wall st firms were all left holding various amts of crap mortgages when the music stops
• side note - those guesstimated default rates were made by PhDs and applied math nerds like joe, who are very smart.  no wall st CEO had any clue as to whether the guesstimates were right.
  
• massive panic as nobody knows how much bad debt the banks are holding, everybody starts selling bank stocks.  the plunging stock values means the equity cushion below the bank's own creditors (banks actually borrow money too) is shrinking, which causes credit rating agencies to freak out and threaten to downgrade said wounded banks (downgrades by rating agencies would trigger defaults with trading partners, effectively blowing up a firm overnight).  this, duh, only serves to intensify selling in those banks, a catch-22, or death spiral, as we like to say.  those banks face bank runs as customers irrationally withdraw money and trading partners shun them, causing bank failures and even more panic
• rinse and repeat, rinse and repeat until global financial system has unwound and stock markets tank and companies can no longer raise money to function normally.
• rinse and repeat, companies unable to raise money to meet payroll lay off workers and go into hibernation mode, the world economy blows a gasket and a second great depression befalls the world
• judging by the way the stock mkt has tanked in recent days, it seems the govt would have done well to avoid this panic by bailing out lehman, which is what they did for bear.  but the political backlash from the first go around made the treasury secty unwilling to do it again before an election.  in hindsight, sometimes the right thing to do is the unpopular thing to do, and with so few americans understanding what's right for the country (due to a lack of education or basic understanding of the financial system), we did the dumb thing.  we blamed wall st greed and cut off our nose to spite our face.  we did it again when we voted down the $700b stabilization (refuse to call it a bailout) package.  this has inflamed investor panic and as a result we are somewhere in the 6th inning of the feared second great depression.  the end.
  

Observations From My Week