Death By 1000 Cuts

In 1933 Congress created the Glass-Steagall act to restrict the size and scope of banking operations, thus preventing the creation of mega-banks (that are now thought to be “too big to fail”). In 1938, Congress created the mortgage agencies referred to as Freddie Mac and Fannie Mae that created a source of mortgage financing, but placed certain reasonable credit restraints on borrowers and lenders.

This seemed to work well. Until Congress, in effect, repealed Glass-Steagell and pressured Fannie and Freddie, made private in 1968, and others to purchase loans made by individuals who entered into mortgage obligations they could not afford that required no money down and no credit checks.  The previous standard of 20% down and credit checks for sufficiency of income protected the lender and had a self-limiting effect on unqualified borrowers.  Meanwhile, the banks consolidated into giant holding companies after Glass-Steagall was repealed in 1999 with a bill initiated in the House and signed into law by President Clinton; this allowed them to enter into businesses that were lucrative through enormous leveraging of assets, but were vastly different from traditional banking.

The bright boys on Wall Street saw an opportunity to repackage these newly minted mortgages that were enabled by new unrealistic standards of credit into financial derivatives called Collateralized Mortgage Obligations. CMOs were divided into segments called "tranches" based on the credit worthiness of the underlying securities.  Everybody made money.  The Wall Street traders made money, Fannie and Freddie made money. The mortgage originators made money. The real estate salespeople made money. And the home owners used the collateral of their home to refinance and take out money that made them rich—for a while—or sold their real estate at a price inflated by easy money.  Of course politicians, who enabled these transactions to take place, looked like white knights to an electorate that was previously unqualified for a loan and to everyone in the food chain that profited from the easy money.

Then interest rates went up or were reset higher by the terms of the mortgage and the whole thing went up in smoke. 

The people who should not have purchased or refinanced (and would not have acted under prior restraints) a home could not pay on the mortgage.  Since the value of the underlying asset for the poorest tranches became unknown, the market value for these instruments went to nearly zero.  And since easy credit dried up the demand for homes (either for habitation or for speculation) declined dramatically, thus lowering the sale price which exacerbated the default problem, and increased the uncertainty over the value of the assets underlying the CMOs. 

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