Housing is a basic human cost. As interest rates declined, property values rose for a variety of reasons, transforming a typical cost into a theoretical profit. People were suddenly able to purchase themselves bigger houses (or at least a house) because it was thought to be a wise investment. Critical to facilitating this reasoning is capital-generating machinery, as in "where is everyone getting this money?" Below is a graphic depiction of the machinery:
At the top (in purple) is the originator. This is our local bank or mortgage broker. In varying ways, the originator sells the loan to a pool of mortgages and receives cash.The diversified pool of mortgages (in yellow) becomes a series of residential mortgage-backed securities (RMBS) through the alchemy of Wall Street magic where two halves can make two wholes and a whole lotta fees. The challenge of capital is the supply-demand constraint - the supply of low risk investments are limited by the demand for low returns. But for RMBS, CDOs (Collateralized Debt Obligations) neatly evaded these constraints, creating "low risk" investments with "high returns." Here's how:
By slicing the RMBS into graded tranches based on cash flow characteristics, securities were created with elevated returns for lower apparent risk by virtue of "diversification" - the theoretical free lunch of academic business. By pooling securities together with lower rated characteristics, say 80% likelihood of payments, which are estimated to pay at different times, securities can be created which model a 90% likelihood of payment.
Through this mechanism, higher risk capital returns are theoretically available without the higher risk. An example may give clarity. If I am a "B" student, it is because I average "B" work over the course of several years. Yet to attain that "B" average, there are many times that I do "A" work, but occasionally do "C" or "D" or even "F" work. Of course, the "F" work is very infrequent, but nevertheless drags me down into the "B" range. By something like CDO machinery, I could erase my "D" and "F" grades as long as they do not happen in the same semester. By doing this, I become an "A" student without changing my study habits.
You can imagine the demand for such a mechanism; it would become school-wide. Unfortunately, such latitude affects study habits. Instead of having the fear of a low grade spoiling my "B" average, I now see that I simply do not have to get all my bad grades at the same time. So as the entire student body moves to higher grade averages, their study habits are going to hell. In this way, the machinery of tranching which lulled the markets into a lower sense of risk by assuming non-correlating payment patterns (either by region or by FICO score or by type of mortgage) also elevated the risk by loosening mortgage underwriting standards.
While the CDOs are now beset with problems because of the high correlation of problems (all "F"s in the same semester), a major challenge is at the bottom of the picture (in red) in the zone of "first loss piece." As the graph indicates, there is normally some relationship between the originator and the first loss piece.
In order to facilitate the transaction, the originator would often serve as a "liquidity provider." If the originator wished to generate a higher volume of mortgages and gain a competitive edge, the originator could serve in this capacity. The upside was enhanced prospective returns (as this is the highest return piece) and, even if lost, at least make the deal happen - with all its lucrative gains and fees.
Some of the more "conservative" originators discovered that it was possible to retain this piece and then hedge it through a "counterparty swap" as a form of insurance against loss. However, as losses increase, the problems here worsen because the counterparty swaps fail (just as insurors do at times), bringing the losses, en masse, back to the originators.
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