What's The Problem With Wall Street?

Edward Lawrence

[An unpublished essay, 19 October 2011]

Back in the 1950's thru the 1970's home mortgages and the financial institutions that issued them were quite different than what we see today. Mortgage loans were made by local banks and savings & loan companies to local residents, and the companies issuing the mortgages held on to those mortgages, making their profit from the difference between the interest rate paid on deposits and the interest rate received on the mortgages. Under this system the bank had an incentive to make sure the person taking out the mortgage was credit worthy, and would be likely to make payments as scheduled.

In the 1980's some Wall Street financial corporations that wanted to expand beyond trading stocks and bonds got the idea of buying the mortgage portfolios from local banks, S & L's, and mortgage brokers and bundling them into collateralized debt obligations (CDOs) to be sold to wealthy investors throughout the world.

Even though the local banks and S & L's held the mortgages for only a short time, they benefited from the fees they got from the Wall Street firm buying the mortgages in quantity. And of course the Wall Street firms received nice fees for their service of bundling and marketing the CDOs, and the wealthy investors got a growing outlet for putting their excess cash to work.

At first the mortgages being incorporated into these CDOs were prime: they has been issued to people with good credit ratings, a job, and an income level high enough to make the monthly payments. However, the local banks, S & L's and mortgage brokers no longer had any risk once they passed the mortgages on to the Wall Street firms to be bundled into CDOs and sold off to investors, so there was no longer a need to make sure that mortgage loans were made only to credit worthy people. The local company originating the loan and the Wall Street corporations bundling the mortgages into CDOs would make their profit even if the borrower defaulted on the loan in a couple of years.

As time went by the demand for investment opportunities by wealthy people increased. To satisfy this demand, banks and mortgage brokers started making loans to people with lower credit scores, people without enough income to make the mortgage payments, and to people without a steady job. (There was a case in California where a person earning less than $15,000 a year was given a mortgage loan of over $700,000.)

At first these sub-prime loans comprised only a small portion of the collateralized debt obligations, but as time went on the CDOs contained a larger and larger share of the sub-prime mortgages. In spite of this, the rating firms such as Standard & Poor's and Moody's still gave them a top AAA rating, thus making the CDO's very marketable. The fact that Standard & Poor's would give an AAA rating to a CDO consisting mostly of sup-prime mortgages may have something to do with the fact that the Wall Street corporations paid a fee to Standard & Poor's for them to do the rating, and if they did not get a good AAA rating from Standard & Poor's they might take their business to Moody's instead.

Due largely to the AAA rating, the largest financial institutions on Wall Street got into the business of buying and selling CDOs in order to increase their profits. The Wall Street corporations put pressure on loan originators to generate as many mortgages as they could. Unfortunately the financial analysts at these corporations did not evaluate the collateral behind these CDOs: the thousands of individual mortgages that were bundled into them.

There were a number of maverick individual analysts, however, who did do the analysis of the mortgages behind some of the CDO's, and what they discovered was shocking. Many of the mortgage loans had been made to people with low credit scores, with not enough income to make the payments once the "teaser" low rate escalated after two years, and who did not have a steady job history. Some of the mortgages had been made without any documentation of job or income history. As time went on the share of sub-prime mortgages in the CDOs increased.

It was obvious to these maverick analysts that in the not too distant future, there would be massive defaults on the mortgages, and this would bring about a drastic decline in the value of the collateralized debt obligations. They asked themselves: How can we profit from this information we have that nobody on Wall Street seems to be aware of?

Their answer: Buy an insurance policy on some collateralized debt obligations. When the value of the CDO's collapsed and had to be sold at a loss, the insurance company would reimburse them for the loss. The premiums paid on the insurance policy would be a small portion of the payment the corporation issuing the insurance policy would make. (Assuming that corporation had not gone bankrupt.)

These insurance policies were called credit default swaps, and a unique thing about them is that, unlike other forms of insurance, there was no government regulation or oversight of them. The people that wanted to bet that the value of the collateralized debt obligations would collapse did not even have to own those CDO's. They could bet on the collapse of CDOs owned by others.

We know now that many people who received mortgages did begin to default, and the value of the CDOs containing the sub-prime mortgages did plummet, a major factor contributing to the Great Recession. AIG, American International Group, was one of the major issuers of the insurance (i.e. credit default swaps) on those CDOs, and was threatened with bankruptcy until receiving a $170 billion bailout from the federal government.

In 2009 the executives and traders in the AIG division that issued the credit default swaps received $165 million in bonuses.

Is there anything that could be done to reduce the abuse that almost lead to the financial collapse on the global economy? Yes. As a first step we can demand that Congress pass and the President sign legislation increasing regulation of collateralized debt obligations, credit default swaps, derivatives, hedge funds, and other exotic financial instruments. The Dodd-Frank bill passed by Congress did very little to regulate Wall Street, and stronger measures are needed if we want to avoid another financial disaster.