To make mortgage-backed securities, securitizers needed MORTGAGES to BACK the securities (editorial decidion to save synthetic CDOs for another day)
The incurable - and very foreseeable -flaw in a business model predicated on turning nonprime mortgages into securities is that the well of borrowers who can actually afford to own a home must eventually run dry.
Guess what happened... Some time around the end of 2004, the supply of potential new borrowers was evaporating quickly. The solution? Start lending to folks who can't afford to own a home (by that, we mean lending to people who can't afford to make mortgage payments). Lord knows, there were and are millions of Americans who fall into that category.
Lenders, either owned or financed by Wall Street, responded to the dwindling supply of qualified borrowers by cutting underwriting standards. First, Wall Street realized that the magic of two or three year teaser rates permitted people to buy homes they had no business buying.
As long as borrowers paid the artificially low teaser-rates long enough for financial institutions to stuff the new mortgages into mortgage-backed securities and sell off the MBS to investors (about a three to four month process), big fees could keep on flowing into Wall Street's coffers.
Mind you, Citi and Merill and Lehman and and Bear knew that these teaser rate loans had to be refinanced (at substantial cost to borrowers) before the teaser periods expired and new, UNAFFORDABLE rates kicked in. That was the plan for the get-go (Wall Street Law Blog has never used the term get-go before - perhaps a freudian slip kind of thing? Get-go does sound a lot like Gekko).
The whole idea idea was to let borrowers' home equity grow for a few years, then refinance the loan so it did not reset to a higher rate.
Thus, these teaser-rate mortgages, mainly 2/28 Hybrid ARMs, were never meant to be 30 year mortgages. Instead, such "affordability loans" were more like leases that had to be renewed every two to three years, or else...
This teaser-rate carousel was a form of Ponzi scheme, and it played a leading role in making the mortgage-backed securities con game profitable.
In a traditional Ponzi scheme, the schemer (usually an investment advisor) uses money received from new investors to pay attractive, but phony, investment returns to prior investors. In a Ponzi scheme, new money bails out the old money. When, eventually, there is a shortage of new victims/investors (ie if there is not enough new money to bail out the old), the Ponzi scheme collapses.
The Ponzi-like twist with teaser rate mortgages is that unqualified borrowers had to be refinanced into NEW mortgages with NEW low teaser rates before the initial (or prior) teaser period expired. Instead of new money bailing out the old, new teaser rate ARMs bailed out the old.
Until, that is, home prices stopped climbing.
When home values stopped appreciating in late 2005, so (obviously) did home equity. Soon, prices started falling. Without the additional wealth produced by ever-growing home equity,nonprime borrowers could not refinance. There were no new teaser periods to bail out the old. Each month, as more loans reset to higher rates, more borrowers could not afford their homes. The Ponzi-like scheme collapsed. Subprime and Alt-A Mortgage defaults skyrocketed.
Eventually, mortgage-backed securities faced cashflow shortfalls and, beginning with the riskiest tranches, issuers of mortgage-backed securities began to default on payments to investors.
So many ways to commit securities fraud... Somewhere Charles Ponzi is smiling.
By Brett Sherman, The Sherman Law Firm
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