The Foreclosure Crisis and Bailouts: A Numbers-Free Explanation of How the Big Banks Set Out to Rob You and Succeeded

Illustration by: Matt Mahurin

Not understanding complicated mathematics or derivative schemes does not mean you cannot grasp the causes of the subprime mortgage crisis and the ensuing foreclosure crisis. In fact, when journalists pretend that this is all too difficult to explain to you they are concealing the truth from you, and as such are complicit in what can only be considered criminally unethical behavior by investment banks and others. I am a layman when it comes to finance, so what proceeds is a laymen’s explanation for these crises because I believe if this was made very clear for everyone, there would be riots.

A few years ago a new tool for fronting money for homebuyers was dreamed up by investment banks. This included the sale of what is known as Mortgage-Backed Securities, of MBS. This is how it works: 

1. Just like in the good old days, a commercial bank who loans us money to buy a house. In exchange, we promise the commercial bank interest and principle on the loan, that is, the mortgage payments. These payments would eventually net the bank more money then it started with, and we would net a house. 
2. However, instead of waiting to get paid back by us, the commercial banks started selling the rights to our payments to an investment bank. The investment bank would give the commercial bank a lump sum, and the commercial bank would forward our payments to the investment bank. This is a good deal for the commercial bank because they unload risk and get cash that they can then lend out to someone else. 
3. The investment bank then creates a fake “company,” called a Special Purpose Entity, or SPE, and hands over the rights to your mortgage payments to the SPE. It also hands over the rights to several hundred of your neighbors’ mortgages to the same SPE. 
4. The investment bank then sells “stock” in the SPE. These stocks are the infamous “Mortgage-Backed Securities.” Those who buy these MBS are people who are willing to pay back a part of the money to the investment bank in exchange for part of your mortgage payments. The folks buying these stocks are typically private citizens or other investment banks.

Got that? It’s:

And everyone’s happy, right? There is more money available for mortgage lenders, which means there is more money available for you and me to borrow to achieve sweet, sweet homeownership. And out there somewhere is someone with money to invest that now has a new trendy way to let their money have babies. The only problem is there is risk, as with all investing. When you invest in a company, that company may fail, and your stock then becomes worthless. With a MBS, if a certain number of folks foreclose, the SPE’s stock is no longer worth what folks paid for it, and the investors take a loss. At least they should, anyway.

Claiming the intent to “insure” the money they were investing in these SPEs, investment banks and others took out different kinds of “insurance policies.” Some of these were CDS, or Credit Default Swaps, but there are many different kinds. Basically the SPE’s investors pay a premium to an “insurance” company and in exchange the insurance company pays out to the investors if there are mass foreclosures.

Some of you may be wondering why I keep using scare quotes. There are two reasons.

1. The idea of insuring an investment is silly. An investment is paying money now for the getting more money later. Getting more money back later is possible only because you are risking losing money. If you turn around and pay even more money out to a third party to negate the risk, you are paying out of what you expect to recoup if you made a good bet. You are reducing risk but also reducing returns. In other words you could have just picked a safer bet with lower rewards in the first place. This is a ridiculous thing to do. Investors lower their risk by trying to make smart decisions about where they invest money, not by investing in any old thing and then paying someone else to take the risk for them. What ends up happening is that investors start hoping that they can collect on their insurance, meaning they end up hoping their investment was a bad one. It’s basically a complicated way of short selling.
2. Mortgages are already “insured” by their very nature. Think about it. What happens to your house when you can’t make your payments anymore? The bank takes it. Your house is the collateral that indemnifies the lender from loss should you not be able to pay back the loan. In theory, if you own an MBS, you are entitled to the house should the mortgages not be paid back. So in other words, these CDS were insurance against losses that your house already protected against. Double insurance? This is a very odd practice indeed.

So what does this mean? It means that all these CDS and etc. weren’t “insurance” at all. They were bets. It means that the people buying your mortgage debt expected you to default, and so made a bet that would be profitable to them if you did.

You might be thinking, “Why would they buy my mortgage debt if they expected me to foreclose?” Answer: What better way to ensure that something goes belly up then to design it yourself? 

After discovering that this “new tool” made money available for home loans that wasn’t available before, banks started making riskier loans then they ever could before. These loans were to people that had bad credit, or didn’t have high income, or didn’t have a down payment. They also made loans that were very difficult to pay off in the long term, aka subprime loans. That's right; I'm accuse them of rigging mortgages to fail. And they pumped these out as quickly as they could. And investors were willing to pay good money for these loans because they knew something very important about them; that they were going to go belly up. They rigged the casino. They bought a very flammable building and took out a huge insurance policy on it, and just waited for the fire.

They had one problem, though. No one goes to bet at rigged casinos. No one insures buildings that don’t pass a fire inspection. In order to make money off a bet, someone has to agree to take the losing side. No one is going to bet against the Super Bowl champs the day after the game, and no one is going to bet we can pay out mortgages when everyone knows we can’t. Investment banks needed a fall guy, someone they could force to make a terrible bet against their will and force to pay up when the foreclosures hit.

They picked us.

They did it by piling the bets onto companies like AIG. AIG gleefully agreed to bet that we would pay back our loans, not because they thought you would, but because they all knew what would happen when we didn’t. It has been commonly held investment wisdom for a while now that when critical banks are in trouble, the government bails them out, making these institutions safer for investing. In this case, they counted on it. A massive transfer of wealth would go from the public coffers (or, more accurately, added to the public debt), pass through AIG, and end up in the pockets of all the folks that bought the mortgage debt that they knew made sure was bad.

And, perhaps worst of all, they get to keep your house, too.

It just came out that Wells Fargo was explicitly doing this very thing I have just described and may have to pay back a small part of what they have reaped from this whole thing. But it is ludicrous to pretend that they won’t get away with it since both Democrats and Republicans are more than willing to turn a blind eye. It’s also ludicrous to think that this was just a few bad apples; it a system where all the decision are made by just a few bad apples. All of them are guilty.

An important question for you to answer if you are facing foreclosure is, why are you being foreclosed on at all? We already paid back the banks for any losses they might have suffered when we couldn’t make our payments when you bailed out AIG. The house exists as collateral to protect the lender from loss. They haven’t suffered a loss because of their so-called “insurance,” and so if your home is repossessed, they are keeping it as a windfall on top of what they have already recouped. There is even some question as to whether MBS holders are getting the proceeds from foreclosed houses or whether the original commercial lender (that was already paid one by the investment bank for your loan) is simply keeping the money themselves. More on this here.

I’ll see you at the riots.