Stellar question. In short, yes. Digging much deeper; From the analytical standpoint, THIS is the absolute foundational crux of the "subprime crisis" as far as I'm concerned. Without this very precise ingredient in the soup, there MIGHT/maybe would have been "a buttload of foreclosed homes". There MIGHT/maybe would have been widespread "dishing" in RE prices (but not 30-50% cratering) There MIGHT/would have been high single- digit percentage losses in loan portfolios spread far and wide. But there WOULD NOT have been screaming flameout trainwreck losses bringing loan ports to 11% and 17% and 23% of their face values; values so unbelievably butchered that nobody in the credit markets had/has the slightest idea how to deal with them, and values so unbelievably crushed that a small little segment of AIG/BSC/LEH could devastate the liquidity of the rest of the company(s)....not to mention the even larger systemic effects.
The raters operated their "models", and hence their behavior on a quartet of beliefs:
1: RE has never drastically declined in value [and thus it never will]
2: That a debt instrument "hedged" or "insured" by a "AAA" rated insurance company automatically, immutably, and to an arbitrarily large degree acquires that very same "AAA" rating enjoyed by the ins company no matter how dodgy the underlying loan is. Never you mind that we [ratings agy "A"] aren't doing our due dilly on the underlying; we'll rely upon [ratings agy "B"] to rate the insurance product and cross our fingers that THEY'VE done their due dilly. Or, if you'd like, [ratings agy "A"] can go ahead and gloss over the ugly details of BOTH the underlying loan AND the insuance product. Where would you like to go today?
3: That in effect, no matter how iffy any given loan is (in terms of the likelihood of being serviced timely including principal & interest) there is, somewhere, some derivative product that can be purchased and "bolted" onto that original loan such that the combo of the two securities will perfectly model the risk-free behavior of US Tsy debt and thus automatically self-imply a "AAA" rating. hahahhhahhahaha.
4: That the intuitively far-fetched belief exists [because we don't question it] as a true reality that every party involved in this transaction; the loan originator; the loan servicer; the insurance provider; and the homeowner; ALLLLLL can and will make virtually guaranteed money from the deal.
Well said. I’ve learned a lot about this topic by reading and reading, and asking questions from people who know what they are talking about.
It seems to me that without the ultimate buyer of these loans being the GSEs, the subprime market could never have built up the huge inventory of bad loans. Since the government was the buyer of last resort, and since the GSEs were buying without any qualms about the quality of the paper, it seems like the banks and brokerage houses thought they had found the real key to eternal prosperity - leave the taxpayer holding the bag, if everything failed. Of course, failure was not a possibility for them.
I had no idea the portfolios were valued at as low as 11% of their face value. I knew the Lehman Bros. auction of their Credit Default Swap instruments resulted with a 5% face value, but the underlying loans themselves are only 11-23%? Whoa! That means the banks are in a world of hurt.
The story of the CDS division at AIG is a story unto itself. The New York Times had an excellent story on it.
Behind Insurer’s Crisis, Blind Eye to a Web of Risk
http://www.nytimes.com/2008/09/28/business/28melt.html?_r=3&ref=business&oref=slogin&oref=slogin&oref=slogin
With all these entities strung out to the end of their resources, I wonder how many banks are truly solvent. If they all used the “bolt-on” CDS paper to hedge their potential losses and then maybe even loaned out more money based on the value of the CDS, then the banks are all essentially defunct, with or without their equity in Fannie or Freddy becoming equal to zero earlier this year.
I know we need financial entities, but maybe the banks should fail, hit the FDIC limits and everyone gets their money according to the original FDIC insurance. Of course then the “right people” would suffer, so that will not happen as long as Paulson can help it.
Great summary. Items like that are the reason to keep coming to FR.