A giant global game of “hot potato was played with trillions of dollars of the worst mortgages ever written. Everyone thought they had gotten rid of the risk — until the music stopped and the potatoes exploded at the same time.
Core Mechanics: How the Machine Worked
- Originators (Countrywide, New Century, etc.)
- Wrote millions of subprime and Alt-A mortgages (liar loans, no-income-no-job-no-assets “NINJA” loans, 100 % financing, teaser rates).
- Made their money on origination fees, not on whether the borrower ever repaid.
- Risk is “pushed away” from the issuer The originator immediately sold the loan to a Wall Street bank (Goldman, Lehman, Bear Stearns, Deutsche, UBS, Merrill, etc.) for cash. → The originator no longer cares if the borrower defaults next month — they already got paid.
- **Wall Street bundles the mortgages into Mortgage-Backed Securities (MBS)
- 5,000–10,000 individual mortgages → one bond.
- The bond is sliced into tranches: – Senior tranches (AAA) get paid first – Mezzanine (BBB or lower) – Equity tranche (unrated, first-loss piece) → Even if many mortgages default, the senior tranches are supposed to be safe because the lower slices absorb losses first.
- The magic trick: turning dogshit into AAA The rating agencies (Moody’s, S&P, Fitch) gave 75–90 % of every deal an AAA rating — the same rating as U.S. Treasuries — because:
- Historical default models assumed house prices never fall nationally.
- Banks paid the rating agencies millions in fees, so there was a massive conflict of interest (“issuer pays” model).
- Structured finance teams at the agencies used Monte Carlo simulations that were deliberately fed rosy assumptions.
- Shopping: If Moody’s wouldn’t give AAA, the bank went to S&P.
- Derivatives on steroids: CDOs and CDO-squared
- Take the BBB tranches that couldn’t be sold → bundle them again into a new vehicle called a Collateralised Debt Obligation (CDO).
- Again slice into tranches → suddenly 70–80 % of the CDO gets AAA too.
- Some banks even took the BBB tranches of CDOs and put them into CDO-squared — a third layer of alchemy.
- Credit Default Swaps (CDS) — the nuclear insurance
- AIG, MBIA, Ambac, and European banks sold hundreds of billions in CDS protection on the AAA tranches.
- This was marketed as “removing the last bit of risk,” so pension funds and banks could buy AAA paper with almost no capital requirement.
How the Germans (and Norwegians, Dutch, etc.) Got Completely Duped
European (especially German Landesbanken and regional banks like IKB, Sachsen LB, WestLB, BayernLB) were desperate for yield in a low-interest-rate world.
What they were sold:
- “Super-senior AAA” CDO tranches that paid Libor + 10–30 bps (tiny extra yield, but still AAA).
- The sales pitch: “Mathematically impossible to lose money — 20–30 % subordination below you, house prices never fall nationally, and AIG insures it anyway.”
- Many bought through off-balance-sheet vehicles (SIVs, conduits) that used short-term commercial paper, so they didn’t even show on the bank’s balance sheet.
Reality in 2007–2008:
- U.S. house prices fell 30–50 % in many states.
- Subprime defaults went from 5 % → 25–40 % in a few months.
- The lower tranches were wiped out almost instantly → losses cascaded upward.
- Suddenly the “super-senior AAA” paper was worth 20–50 cents on the dollar.
- AIG couldn’t pay the CDS claims → U.S. taxpayer bailed them out → money flowed straight through to Deutsche Bank, Société Générale, Goldman, etc.
Concrete German losses (selected):
| Bank | Estimated write-downs/losses |
|---|---|
| IKB | €13 billion (almost bankrupt) |
| Sachsen LB | Sold to LBBW for €1 after huge losses |
| WestLB | €20+ billion, later broken up |
| BayernLB | €15+ billion |
| HSH Nordbank | €15+ billion |
| Total German banking sector losses on U.S. subprime → ~€100 billion |
Why the Ratings Were So Wrong Even Though Everyone Knew the Mortgages Were Bad
- Issuer-pays model → rating agencies competed to give the highest rating. Internal emails later revealed (2007): “Let’s hope we are all wealthy and retired by the time this house of cards falters” — S&P employee. “We rate every deal. It could be structured by cows and we would rate it” — another S&P email.
- Garbage in, garbage out models Agencies used 1990s–2004 data when house prices only went up. No stress test for nationwide price declines.
- Correlation assumptions Models assumed defaults in California were independent of defaults in Florida. In reality, when the music stopped everywhere, correlation went to almost 1.
- Regulatory arbitrage Basel II rules let banks hold almost zero capital against AAA paper. So the incentive was to manufacture as much AAA as possible.
Timeline of the Collapse (Very Short)
2006 – Peak of housing bubble Early 2007 – First subprime lenders start failing (New Century bankrupt April 2007) July–Aug 2007 – Two Bear Stearns hedge funds blow up; German IKB needs emergency bailout Aug 2007 – BNP Paribas freezes three funds → global money markets freeze Sept 2007 – Northern Rock (UK) run in UK March 2008 – Bear Stearns rescued by JPMorgan + Fed Sept 2008 – Lehman fails → panic Oct 2008 – AIG gets $185 bn bailout → most of it pays European banks and Goldman
Bottom Line
The entire system was built on the belief that housing prices could not fall nationwide and that slicing and dicing risk magically made it disappear. When prices did fall, the lower tranches were wiped out instantly, the AAA ratings proved worthless, the CDS counterparties (mainly AIG) collapsed, and the risk that everyone thought they had “distributed” simply blew up in the face of anyone holding the paper — especially conservative German, Norwegian, and Asian institutions that thought they were buying the safest bonds in the world.
That is how a few hundred billion dollars of bad U.S. mortgages almost took down the entire global financial system.
DEFINITIONS
MBS (Mortgage-Backed Security) Bundles thousands of home loans into one bond. Why it’s bad: Removes all incentive for the original lender had to check if the borrower could actually repay — the loan is sold the next day, so garbage mortgages flooded the system.
CDO (Collateralized Debt Obligation) Takes the risky leftovers of MBSs (and other debt), rebundles them, and pays rating agencies to stamp most of it AAA. Why it’s bad: Turns obvious junk into “safe” bonds that pension funds and banks were allowed (or required) to buy; when the underlying loans blew up, trillions in supposed AAA paper became worthless overnight.
CDS (Credit Default Swap) Unregulated “insurance” on MBSs and CDOs with no capital reserves required. Why it’s bad: Let institutions like AIG write hundreds of billions in guarantees they could never pay; when the bonds defaulted, it created a chain reaction that almost collapsed the entire financial system (AIG alone needed $185 bn bailout, most of which went straight to CDS buyers).