by Craig Eastland

Before we talk about the financial crisis, let's talk about the old days. Ten years ago, a bank took a risk when it wrote a mortgage. If the borrower defaulted, the bank had to evict the borrower and then hold an auction to sell the house. Until the auction, the bank was responsible for maintaining the house and paying the taxes. To avoid becoming auctioneers and absentee landlords, banks spent a good deal of effort determining the borrower's ability and willingness to pay back the mortgage.

But over the last 10 years, mortgage banks and investment banks found a way to remove the default risk from writing mortgages. They used something called securitization (or asset-backed finance) to separate the risk from the money and transfer the risk to someone else. Securitization allows a business (or originator) to turn a steady trickle of cash into a big flood of cash. Any trickle can be securitized: credit card payments, student loan payments, and of course, mortgages. Mortgage-backed securities (MBS) were developed by federal housing agencies in the 1970s as a way to sell a bunch of mortgages all at once. During the 1990s, the Resolution Trust Corporation, suddenly in possession of thousands of mortgages from failed savings and loans, worked the bugs out of the MBS process.

Investment banks like Bear Stearns and Lehman Brothers privatized the MBS process developed by the government. Here's how they "packaged" mortgages into MBS:

1. The originator sells all of its mortgages to the investment bank at a discount.

2. The investment bank organizes a new company called a special purpose vehicle, or SPV. The SPV usually has a funny name such as "Bear Stearns Alt-A Trust."

3. The SPV buys the mortgages from the investment bank.

4. The SPV issues securities that it sells in the public markets. Because the securities are backed by mortgage payments, they are called mortgage-backed securities.

This is how the default risk changes hands: SPVs, also called pass-through entities, aren't real companies. The only thing they own is a pool of mortgages. Their only source of income is the repayment of the mortgages. The securities they issue transfer, or pass through, all the attributes of the underlying mortgages–including the risk–to the investors who buy them.

Money from MBS deals, mostly borrowed, was the gas that inflated the housing bubble. As long as housing prices went up, MBS paid dividends. Because MBS were a good investment, there were investors to buy them. To feed this hungry market, investment banks needed more mortgages to package. Consequently, originators had an incentive to write as many as possible.

During this time, both investment banks and mortgage originators started to explore avenues that, in retrospect, look very risky. In these behaviors were the seeds of the collapse.

Banks do a lot of business with borrowed money. Regulatory requirements control how much money a bank can borrow by comparing the amount of money the bank owes to how much cash it has. Investment banks (which don't really exist anymore) were different from normal banks: They were regulated by the Securities and Exchange Commission (SEC). Former SEC rules, based on international banking standards, let investment banks borrow more money than banks regulated by the Federal Reserve. According to the testimony of Luigi Zingales, a professor at the University of Chicago Graduate School of Business, Lehman Brothers owed 30 times more money than it had on hand.*

What did these investment banks do with the money they borrowed? They bought mortgages to turn into MBS. The borrowed money went back into the hands of the originators, allowing them to write more mortgages. Thus, as much as 30 out of every 31 dollars sloshing around in the housing market was borrowed money. This flood of cash made it possible for borrowers to get bigger loans. Bigger loans meant speculation and bidding wars. Speculation meant constantly rising home prices.

Eventually, all the people with good credit had houses, but the market for MBS did not wane. The originators realized that because all the risk was passed to MBS investors there was no need for them to properly vet mortgage applicants. So the mortgage application process was eliminated and new kinds of mortgages were created to allow people to buy houses they couldn't afford.

In hopes of wringing a few more dollars out of the mortgage securitization machine, investment banks began creating an interconnected web of transactions that would eventually pull down the entire investment banking industry. In the creation of this structure, the credit rating agencies played a crucial role.

Eighty percent of securities are purchased by large institutions, e.g., banks, pension funds, and investment banks. These large entities are regulated to protect their shareholders. They can't invest in just anything. They are only allowed to buy securities that are rated investment grade by a nationally recognized statistical rating organization (NRSRO). NRSRO was coined by the SEC in the 1970s to identify reliable rating agencies. This SEC shorthand was incrementally incorporated into other laws. Today, the NRSROs wield enormous power; many deals can't be sold if they aren't investment grade. MBS deals are so complex they aren't even possible without a rating.

A rating from a credit rating agency is a prediction of the likelihood of default. Each credit rating agency has six or eight ratings, of which the top few are investment grade. The rest are called "junk." The highest rated securities (Aaa for Moody's and AAA for S&P) have a very low average chance of defaulting. Historically, default rates for triple-A securities have been less than 3 percent.

Changes in mortgage lending produced a housing market unlike any that had ever existed. Default risk was rising: More mortgages were being written to riskier "subprime" borrowers, and ordinary people were turning into real estate speculators. Traditionally, mortgage lending was a low-risk activity. People don't want to get kicked out of their houses so they sacrifice elsewhere to ensure that the mortgage gets paid. But speculators, who have little or none of their own money invested, are much more likely to default if housing prices go down.

Investment banks responded to the riskier housing market by tweaking their MBS products to retain triple-A ratings. They employed financial engineers or quants to apply mathematical tools to MBS offerings. Quants are the people often referred to as Wall Street's "rocket scientists." (Many of them are former rocket scientists.) The quants redesigned ordinary MBS with an eye toward making them default-proof. For example, they arranged MBS offerings into tiers called tranches. They panned the gold, in the form of the least risky mortgages, out of the underlying mortgage pool and assigned it to one tranche in order for that tranche to be rated triple-A. Lower-ranking tranches were subordinate; holders would only get money after the higher tranches did.

The rating agencies helped the investment banks get triple-A ratings for these new securities through connivance and stupidity. All the rating agencies have "consulting" divisions that help issuers get better ratings, but they relied on flawed data. They didn't understand that the housing market had fundamentally changed. The models of mortgage default that the rating agencies were using predated the MBS-fueled housing market. It was, as former Moody's managing director Mark Adelson told the New York Times, "like observing 100 years of weather in Antarctica to forecast the weather in Hawaii."†

The circular MBS system continued to spin, making all participants rich. To meet continuing demand, some investment banks ventured onto thinner ice by creating complex securities called collateralized debt obligations (CDO). CDO were issued by special-purpose vehicles that bought and sold MBS (these vehicles were a cross between an MBS SPV and a mutual fund). The securities that they issued were divided into multiple tranches. CDO weren't backed by a pool of mortgages; they were backed by a pool of mortgage-backed securities. Generally, CDO securities were an even riskier investment than MBS because the CDO tranches were subordinate to all the tranches of the underlying MBS. In spite of this, many CDO tranches were rated triple-A.

This is where it gets really complicated. The investment banks used one more strategy to make their MBS a more attractive investment. They employed a derivative, called a credit default swap (CDS), as a hedge against default.

Hedging is essentially making a bet and, just in case, also making the opposite bet. It's like betting $100 on the long shot and $30 on the favorite. The potential gains are less, but so are the potential losses.

A derivative is a financial instrument that derives its value from the value of something else. Essentially, a derivative is a bet on what the price of the underlying item will do. For example, a fixed-rate contract with a heating oil company is a derivative. That's because the contract itself has value, but its value depends on the price of heating oil. Imagine you typically use 100 gallons of oil during the winter and you sign a fixed-rate contract when the price of oil is $4 a gallon. The following week the price goes down to $3 a gallon. Your heating oil company owns a contract worth $100 (the difference between the market price of oil and the contract price). If the price of oil stayed at $4, the contract would be valueless, and if the price of oil went up to $5 (as you expected it to) the contract would be worth $100 to you.

Hoping to further insulate their MBS from default, investment bank-SPVs contracted with insurance companies, such as American International Group, to insure their securities against default. The transaction was simple: If the MBS stopped paying dividends because of default, the insurer agreed to give the SPV the money to pay the dividends. In exchange, the SPV paid insurance premiums. The SPV had thus "swapped" some of the investor's default risk for premium payments.

As a way of making MBS more marketable, these transactions look like a smart idea. Think about our heating oil example: If you're worried that you might not have $400, you might buy insurance. In exchange for your premiums, you'd get the insurance company's promise to give you $400 in the event you don't have the money. These CDS hedging transactions look more questionable on the insurer's side. Because huge sums of money were involved, the SPVs asked for cash collateral to guarantee that the insurer would really meet its obligations. In addition, if the MBS were downgraded by the rating agencies, the insurer had to come up with more collateral.

The CDS market is, perhaps, the most astonishing aspect of the financial crisis. It grew in a tiny loophole in the Commodity Futures Modernization Act (CFMA), Pub. L. No 106-554 (codified in scattered sections of 7, 11, 12, and 15 U.S.C.A.) and became a 35 trillion dollar casino. In 1999, the President's Working Group on Financial Markets advised Congress that the CDS market was too tiny to be regulated and the CFMA exempted it from the jurisdiction of the Commodity Futures Trading Commission and the SEC. In 1999, CDS transactions were seen as a stabilizing factor with limited growth potential.

What the President's Working Group did not anticipate was that the insurers would start writing CDS agreements for parties wholly unrelated to the underlying transaction. Let's go back to our gas contract example. Imagine that I, a third party without any interest in your contract, convinced my insurance company to "insure" your contract with the heating oil company. I pay premiums, and if you can't meet your obligation, my insurer pays me $400. It doesn't sound like insurance, does it? It sounds like I'm betting you won't be able to pay. Also, my insurer is betting that most people like you will be able to pay.

All the pieces are now in place. Next: Housing prices start to go down, and the matrix of interrelated deals collapses.

Formerly head of reference at Fried Frank Harris Shriver & Jacobson LLP in New York, Craig Eastland is now a West librarian relations manager serving law librarians in New England.

*Turmoil in the Financial Markets, Hearing Before the Comm. on House Oversight and Government Reform, October 6, 2008 (statement of Luigi Zingales, Professor of Finance, University of Chicago).

† Roger Lowenstein, Triple-A Failure, N.Y. Times, Apr. 27, 2008, at 36.