This suggests a problem or problems extending well beyond a bust in the housing market. It is noteworthy, but hardly earth-shaking, when a boom goes bust. In this case, the sudden contraction in housing prices trapped some who bought late in the cycle in insupportable mortgages, and they defaulted. Some of the lenders stuck with these bad loans—generally highly aggressive firms that specialize in a marginal clientele (New Century Mortgage)—were forced into bankruptcy. That’s pretty much the baseline case, the generic model for any market contraction. This difference this time lay in the volume of money that had been put at risk, and the number of players involved, both of which were much larger than usual. When the game stopped, some very surprising players were left holding very large bags—bags full of dodgy mortgages. Thrust to center stage was a previously little-noticed network of conduits that connected an army of fly-by-night lenders and their equally suspect clients to some of the most the world’s most prestigious financial institutions. No less unusual was the fact that the lesser participants, who usually get all the worst of it in such head-on encounters, were not alone on the list of grievously injured. New Century Mortgage went bankrupt, but so did Bear Stearns, and a number of even more exalted names were scrambling literally across the globe looking for emergency cash.
It was as if Joe Fourflush, pouring a bucket of cement into the plumbing of his foreclosed home in Las Vegas, was backing up drains all over Wall Street. Along with Joe and thousands like him, the eviction list from the subprime entanglement included the chief executives of Citigroup, Merrill Lynch and UBS AG.
The story is very much one of “knock-on effects,” as the post mortem by the Greenlaw group phrased it (Greenlaw et al, Pg. 12.). And, once started, the effects knocked-on very quickly. Subprime mortgages had been the foundation of a multi-billion dollar bond marketing business, in which large Wall Street investment banks bought them, packaged them into complex securities called collateralized debt obligations (CDO’s), and sold them through special entities, usually trusts, called structured investment vehicles (SIV’s). These entities borrowed short term and relatively low rates and invested long term at higher rates. Subprime mortgages provided very attractive rates at what appeared to be relatively little risk.