I know Michael Lewis from his book Moneyball where he laid out the Oakland As' strategies using sabermetrics to draft and acquire players and to put together a major league baseball team. He was able to explain some of that in ways that are very easy to understand, even if I wasn't a big baseball fan (which I am). So when I saw this book by Lewis explaining the subprime mortgage crisis, I wanted to see if he could explain it in a way that made at least a little sense to me.

He has been successful. I am not quite through with the book yet, but I'm following the details of what happened to precipitate the whole thing. I always wondered how around 8% of total mortgages in this country could bring down financial giants. (I'm not sure of the accuracy of that 8% - it's just a number I've heard often.) I knew instinctively that there was more to it than that, but I didn't know what it was.

Lewis tries to explain what happened that made these homeowners' individual hardships come down on the very fabric of our capitalistic society, and he seems to say that it is really hard to spell it out because the ideas behind the whole thing are just totally ridiculous. First, that banks and mortgage lenders would do loans to people who could afford them in the short term but almost certainly would NOT be able to afford them in the long term. Then that they would allow these borrowers to continue to use the "equity" created by inflated home costs to fuel more debt and spending on their part. Then that they would allow them to not even pay INTEREST on these loans - rolling the interest into a larger principle amount somewhere in the future. These buyers had nothing invested in their homes except for fees and maybe a very small down payment (but often not even that). They weren't making ANY payments on the loans.

The banks and lenders didn't care, though, because they were selling the loans off to another agency as quickly as possible. And then big concerns on Wall Street were packaging these loans into bonds and selling off the bonds to investors. These bonds were backed by loans that almost certainly were not going to be repaid in full, and in the end, the holder of the mortgage was going to own a house, not a note from a borrower. And what happens when there's a huge supply of these types of houses and no buyers? Prices plummet.

But that's not all. Some smart investors bought insurance on these bonds. They didn't buy the bonds themselves - they bought insurance on stuff they didn't own. For this insurance they would pay a "premium" of maybe 2.5%. So for example, a 50 million dollar triple b rated bond backed by lots of terrible mortgages was insured for 1.25 million a year. The life of the bond is the same as the life of the mortgage - 30 years. So theoretically you could end up paying 37.5 million in premiums to insure this bond if it goes belly up. (Remember, this is a bond you don't even own.) But these smart investors recognized that the loans backing the bonds were mostly adjustable rate mortgages with teaser rates that lasted for 2 years and then the interest would rise dramatically. At that point, a lot of people who might be able to barely afford the payments on their mortgages now were not going to be able to afford them any longer. So they were figuring they'd have to pay the premiums for two years, then loans should start going bad and their credit default swaps (the insurance they were purchasing) would pay off for the full value of the bond. (The higher rated the credit default swap, the higher the premium charged.)

But someone had to be buying the other side of these credit default swaps - and for a long time that someone was the huge company AIG. (Sound familiar?) But not only AIG - many banks and big Wall Street firms owned the other side of these instruments. The things were generating a steady cash flow of premiums each month, and this was positive income. After all, they'd only become liable for the amounts of the CDS if the bond went to zero.

For those smart investors, there was no question that the bonds would default - the only question was "when?" And this is where I am now in the book - just finding out what happens when they start to default. The timing of this event was apparently artificially manipulated by the big houses and by their manipulation of Moody's and S&P rating agencies, so it didn't come immediately as the default rates of the underlying mortgages started to climb - but happen it did, as we all know.

Which begins to explain how a relative handful of mortgages in default could precipitate the near-collapse of our entire financial system. It wasn't the mortgages really. It was the greed that sold and resold these mortgages in the forms of bonds and securities which basically had no value, and the fact that it was perfectly legal to place bets (almost literally) on whether people could pay these mortgages or not.

I used to think simplistically, when I first heard about this stuff several years back, that they just needed a way to force refinances of these troubled properties. The best way to make them worth something was to keep their owners in them. As I read this book, I realize that it went far deeper, and it really didn't matter if they could refinance at lower rates, the bonds were still bad, and the bets placed were still going to bankrupt those on the wrong side of the bet. AIG "insured" way more of these CDS's than they had assets. Any sort of honesty, either in regulation from the government, or ethical action on the parts of Wall Street and the financial houses, would have prevented this from happening. Someone knew, as they packaged these mortgages into bonds, that they were essentially worthless, ticking time bombs set to go off two years from their inception.

It becomes obvious that Wall Street, not homeowners, ultimately built their own mess, and caused all the problems.

I'll try to post more on this when I finish the book and digest it a bit further.

Till then, sorry for the long post.