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3.2 The Sub Prime Mortgage Bubble – Part 1

Now, let us take a brief glimpse at the sub-prime mortgage bubble. The loop starts with a junior loan officer at a small
mortgage company making a pitch to a recently married couple with a baby on the way. The young couple is just starting out in life and they watched an ad on television that said that you could buy a home with no money down. The loan officer confirms what they have heard and assures them that despite their lack of means, they could have their little dream home, “Not in ten years! Not in five years! But today! Not only that, but they can be in the new home for a full six months without ever having to pay a penny.” The wife is a little hesitant, but her husband assures her that many of their friends have done it, so why be left behind. “Let’s go for it”, he says to his wife, and she finally gives in.

Meanwhile, all the other salespersons in the company are diligently signing up new customers and in short order all their funds are fully committed. Th at is great. But, what do they do now?

The account manager then approaches the bank president, and says, “Well I just heard of this new product, called a mortgage-backed security, which allows investment dealers to use mortgages as collateral for securities. Why don’t we pool our mortgages and sell them as one package to one of these companies? Then we can go back to doing what we do best, selling mortgages.”

The President thinks it is a capital idea, and in short order an investment house buys the mortgage company’s entire loan portfolio. They, in turn, use it to secure shares in the mutual fund they are offering to investors. Shares are sold to investors as well as institutions. One of these institutions is a much larger investment fund based in New York. It now bundles the investment with other similar securities and creates a new fund that is once again sold to investors. A fund in Singapore likes the investment house’s balance sheet and purchases their firm along with its entire portfolio. And so it goes. Eventually, these securities are floating in the system long enough that they are randomly spread throughout the world’s financial system. At this point, the product has been diluted and blended so many times that it would be close to impossible to determine who is actually holding the paper on our young couple’s mortgage.

Then everything goes sour. The housing bubble bursts and the mortgages securing the securities are worth next to nothing. The mortgage company is no longer on the hook as they sold the mortgage to the first investment house. They, in turn, passed off their securities to their clients, taking commission on the sales. All the insiders were smart enough to keep passing it on. Each time the debt was passed, it was re-bundled, artfully packaged, and profit was taken. It is like a huge game of ‘hot potato’ where the trick is to pass on the security as fast as you can.  Everybody is doing just fine, as long as they are not caught holding the potato when the game ends.


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