Corporate & Securities Law

Mortgage securities rise and fall, a Story Mary Shelley would love...

Part 1 of 2.

Confluence is a great word.  It means, in essence, a "coming together."  Most often, the term confluence is used in connection with rivers.  Probably, the most famous confluence of rivers is in Pittsburgh, where three major American rivers eventually merge somewhere around the Steel city's semi-famous (at least to geography buffs) golden triangle.  

One gold star goes to the first person who can name the big three rivers.  Comments are open below.  But I digress.

The confluence discussed in this post has to do with financial disaster, not rivers. This piece is about a very rare confluence of economic conditions, electrified by almost unbelievable opportunism and greed by investment banks and others, that pushed the world into the most serious financial crisis since the Great Depression.

These days, Wall Street executives frequently invoke terms like hundred year storm,<  perfect storm act of god when they cross their fingers and deny the responsibility they certainly deserve for pocketing millions and millions of dollars as a reward for jeopardizing the entire world economy.

< The confluence of economic conditions that Wall Street happily exploited ? and not the foreseeable collapse of the housing and credit markets - was the true hundred year storm.

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• First, the end of the internet stock bubble followed by the humongous shock to U.S. economy from the September 11 terror attacks resulted in the Fed taking interest rates to historic lows, and holding rates there longer than ever before;  

• Second, low interest rates meant Treasury yields were so low that pension funds and other major institutional funds needed investment grade instruments with significantly higher returns than United States bonds in order to avoid invading their funds? corpus (principal) to make required payouts (expansion on this topic requires its own blog post).  For purposes of this post, it is only necessary to understand that fixed-income fund managers restricted by law or charter to investment grade securities were desperate for yield.  This situation, if not unprecedented (I am a lawyer, not an economist) is extremely unusual.  

• Third, Again thanks to low rates, money was so easy and cheap to borrow - especially for banks - that it was practically free.

• Fourth, Cheap money (low interest rates) almost always is manna for the housing industry. Easy credit and low interest rates (and a host of similar factors too long to spell out here) allowed people to afford monthly mortgage payments on homes they never thought they would be able to afford. Housing went through the roof, and people accumulated amazing amounts of home equity (sometimes called found money) due to the increasing value of their homes. In short, most individuals could tap into the wealth produced by their homes to avoid possible mortgage delinquencies (and to put in pools, surround sound, etc.).

• Fifth (and you thought the confluence of three rivers in Pittsburgh was impressive), broker-dealers like Bear Stearns and Lehman Brothers were very experienced with a set of financial products that they believed they could market and sell to ?greater fools? ? especially all of those fund managers desperate for yield.  These products ? perhaps you?ve heard of them - have names like mortgage-backed securities (MBS) and collateralized debt obligations.

• Sixth, If Wall Street excels at anything, it is spotting an opportunity to exploit others for profit. In this case, subprime borrowers, many of whom would eventually face disaster, and fund managers (including international institutions and foreign governments) were to be two classes of victims.  If... if... if only Wall Street could get investment grade ratings with securities made from pools of less than investment grade quality mortgages. Enter the quants (actually, they had been working on this stuff for a while already). With complex mathematical computer programs, and a lot of money in "fees," investment banks were able to bribe, err, collaborate with the ratings agencies to obtain the much needed "investment grade" stamp of approval.  

Now, all the pieces were in place and the money train pulled onto Wall Street.  It arrived regularly for about five years.  And then Frankenstein's Monster came along.  Read about that in part II.