(For previous posts in this series, see here.)

The real estate boom fueled by the easy availability of subprime mortgages was a classic pyramid phenomenon, entirely dependent like all such phenomena on an endless stream of new buyers coming along willing to pay the inflated prices. When the crash came, as it inevitably does with all schemes that are based on expectations of permanent and rapid price increases, it turned out to be financially advantageous for many people who had taken these loans to declare bankruptcy and simply abandon their homes and walk away, since the money they owed was often more than the house was worth. Some became homeless as a result, but others who had bought these properties more as investment vehicles did not fare too badly. Many had put no money of their own as down payment so they had essentially rented the houses for a few years, often at below market rates.

But when the crash came, the repercussions extended far beyond just the actual homeowners. The mortgages sold in the secondary markets had been bought by those who bundled up a lot of them into aggregated units, with the impressive name of SIVs (Structured or Special Investment Vehicles) that were then bought and sold like other commodities in the securities market. The links to the value of the actual pieces of land on which these securities were supposedly based became more and more tenuous and even disappeared. In fact, the ownership of the actual properties is now so murky and obscure that cities like Cleveland are finding it hard to find out who actually owns the mortgages on abandoned properties, in order to get them to pay for their maintenance and upkeep. As a result the city has sued twenty one investment banks that dealt in these SIVs, trying to recoup the losses that the city is incurring as a result of all these defaults and the resulting abandoned and decaying properties that are further driving property values down.

The bundled mortgages were grouped into different classes of SIVs, depending on the supposed risk of default. The price of the different SIVs then became primarily determined not by the actual value of the properties of which they are made up (that link to reality was severed early on) but by the ratings that these SIVs received from the appropriate credit rating agencies. Those ratings are supposed to reflect the actual risk of default of the mortgages in the bundles, and are supposed to be assigned on the basis of careful scrutiny of the mortgage portfolios. That did not happen. The rating agencies gave higher ratings than the creditworthiness of these mortgage bundles deserved, thus making these SIVs seem more valuable than they were. (The ratings agencies themselves are now under scrutiny for this practice by investigators, as people seek to find out who is to blame for the debacle.)

Meanwhile, bond insurance agencies like Ambac, MBIA, and FGIC that normally insure safe municipal bonds against the unlikely possibility of default decided that that was not providing enough profits and eagerly looked to expand their operations into the booming subprime mortgage market. They started underwriting these SIVs in the event of default, based on their inflated values and credit ratings. This caused the supposed financial wizards who buy and sell these kinds of securities based on their ratings (since they rarely know what the securities actually contain) to bid up the prices of these supposedly ‘good’ investments.

The transfer of SIVs became like the children’s party game of passing the cushion, where these securities rapidly changed hands, their prices rising because of the commissions paid, their inflated credit worthiness ratings, and the underwriting by supposedly reputed insurance agencies. When the music stopped and the prices dropped, those investment banks left holding the SIVs suddenly found no buyers for their rapidly depreciating assets. The top investment banks in Wall Street have already sustained losses of $120 billion because of the losses in their subprime mortgage portfolio, and the story is not nearly over.

Now that many of these SIVs are almost worthless, the insurance agencies that underwrote them are also at risk of going bankrupt, since they insured these securities against losses. Their own credit ratings are being downgraded, which can be disastrous to their ability to obtain new business.

So we see a domino effect, with the losses incurred by the deflated SIVs hitting the investment banks, the credit agencies that gave them undeserved ratings, and the insurance agencies that backed these securities without sufficient case reserves. In addition, we have the homeowners who have lost their homes due to foreclosures, the cities that have to deal with the blight of abandoned homes, and the schools and cities that have lost tax revenues due to the drop in home prices. The fallout is also affecting those homebuyers who had good credit (i.e., ‘prime’ borrowers). As a result of the subprime crisis, banks are tightening credit and raising interest rates on even those people with good (i.e. ‘prime’) credit and now some of them are facing foreclosure and bankruptcy, so the subprime label for the crisis is becoming a misnomer. The scale of the disaster has still not been fully felt by the general public.

We are now seeing the government scrambling to provide subsidies to these companies, either by lowering interest rates enabling them to borrow money more cheaply to cover their losses or by giving them loans or trying to arrange consortiums for financing their losses, and other forms of subsidy. The British government, for example, has invested $26 billion in Northern Rock Bank when that bank’s mortgage based assets sank in value, and is considering giving it even more. Similar bailout measures are being proposed in the US.

Like many rich people who praise the virtues of capitalism and are quick to condemn giving welfare to poor people saying that it is ‘socialism’ and rewards bad behavior, the investment banks and insurance industries are totally shameless when it comes to demanding that the government bail them out when they themselves get in trouble and are in need because of their own greedy and reckless behavior.

Next: Two case studies in disaster

POST SCRIPT: Doctor House is Dr. Yahweh

“Religion is a symptom of irrational belief and groundless hope.”