How the Toxic Assets Were Magnified

One of the interesting aspects of the financial crisis is how a relatively small sector of the mortgage housing market — subprime — was able to infect the entire financial system. The WSJ has a very good article explaining how this was done (warning, it’s a little on the wonky side):

In a memo last week, panel Chairman Sen. Carl Levin (D., Mich.) said Goldman’s work “magnified the impact of toxic mortgages” by replicating mortgage securities in debt pools known as collateralized debt obligations as well as CDO derivatives, and also in an index that tracks subprime bonds.
The subprime mortgages that caused big losses generally were packaged into CDOs, in which dozens of mortgage-backed bonds were pooled together and slices of the CDOs were sold to investors. Another version of these CDOs didn’t contain actual mortgage bonds but were linked to them via derivatives called credit-default swaps. Through the use of derivatives, banks created many of these synthetic CDOs using the same mortgage securities, all of which would rise or fall in value depending on how the mortgages were performing. With synthetic CDOs, those who had bet that the loans would perform well were on the hook if their performance deteriorated.
In effect, the documents said, Wall Street was “copying and pasting” what turned out to be the worst-performing securities of the mortgage boom. Such activity helped multiply opportunities for hedge funds and traders who wanted to short the housing market, but magnified the losses of those on the other side of the trades. To short a trade, in this instance, is to bet the housing market will turn down.

In the Washington Post, Heidi Moore takes on the silly notion that only sophisticated were hurt:

It’s not just the big clients, however, that get hurt. What Wall Street would like to ignore when it is taking bets in its casino is that a big pile of chips on the table come from regular consumers — from their bank deposits, retirement accounts, credit-card balances, car loans and mortgages. That’s why the distinction between these sophisticated investors and everyone else is nonexistent. When Wall Street banks omit information and draw profits from “institutional investors,” that means they are taking money from your pension funds, your school endowments, and your city and state governments. Other sophisticated investors include hedge funds, which take money from those pension funds, or private-equity funds, which own companies that employ 10 percent of all Americans.
Pension funds, for instance, are considered “sophisticated investors” on Wall Street. But those are just pools of retirement money owed to workers. The pension funds, looking to expand their stash, invest in stocks and bonds sold by Wall Street. These pension funds also give their money to other funds, such as hedge funds and private equity funds, that invest that money in riskier investments, perhaps troubled companies or distressed mortgages. Pension funds play the Wall Street game to score a healthy return — but when they lose, the money lost belongs to regular people.

Posted by on May 3rd, 2010 at 9:28 am


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