Legal Commentary

The New York Times recently ran a story about a journalist who asked the most basic, and therefore (?) toughest, question about subprime loans back in 2006: "Why are they lending money to people who can't afford to pay it back?"  Eventually NPR News and the radio show ?This American Life? collaborated in a one-hour program called ?The Giant Pool of Money? (audio and transcript here). 

There may be other "Cassandras" out there.  I was reading Frank Partnoy's 1997 book FIASCO: The Inside Story of a Wall Street Trader a few months ago and came across the passage below.  Maybe some crucial difference between collateralized debt obligations (today's CDOs) and the collateralized mortgage obligations (CMOs) makes this less prescient, but it did make me wonder whether we should be so surprised. 

Partnoy explains that home mortgages are pooled together and that CMOs are "strips" of home mortgages, the most common of which was either an "interest only" piece or a "principal only" piece, although there were also more complex CMO derivatives with snazzier names.  He goes on to warn that:

Predicting prepayments of mortgages isn't easy, and every investment bank has multimillion dollar computer models for valuing CMO derivatives.  Yet, even when modeled correctly, some of the most volatile CMOs can become worthless almost instantly....

What makes CMOs especially dangerous is that although they're extremely risky, they can appear quite safe.  One deceiving and dangerous aspect of CMOs is their credit rating: AAA.  ...  Because mortgage payments are so unpredictable, even the most sophisticated investment banks that actively trade mortgages have suffered significant losses.