The real estate boom of the past decade resulted from the explosive combination of a few financial innovations greatly expanded during the previous decade most often with the help of calculated deregulations offered by politicians to their biggest benefactors. Structured finance, credit default swaps, and sub prime lending all moved into high demand and complicated structures. Most regulators, generally insiders, only saw the upside of these new structures and since they were sold to sophisticated investors well versed in risk and leverage they were subject to limited oversight by the SEC. Credit default swaps were protected by regulatory indifference and the Commodity Futures Act and Sub prime was fueled with a wink and nod approach by the Fed. The lack of oversight was intentional and had taken many years of deregulation to accomplish but at this point it was what both Wall Street and politicians wanted.
Traditionally banks had structured financial assets tied to the real economy. I.e. stocks, bonds, currencies, gold, etc. Structured products on the other hand were generated to have any set of given properties and returns they wanted and were backed entirely with derivatives. (Side bets on other financial assets) So you can either invest in complicated algorithms that produce returns based on performance of actual product or you can invest directly in the product that the calculations are based on. To complicate the issue further it is also possible to invest in a hybrid structure that contains both real assets as well as derivative bets against other real assets in a series of highly complicated mixes.
The advantage of structured finance is twofold. First it creates new assets that can be invested in while not being limited to OTC stocks and bonds. Structured finance as its name implies could be engineered to very specific investor terms of yield and timing which was essential for timing liabilities of the investors. Secondly by creating assets that were more customized for investors, businesses ability to raise capital should be easier.
As an example if an airline flight across the world were the real asset being invested in an investor would be hedged against possible risk if it included an option to buy oil at a cheap price in the future. Thus if oil prices rise hurting the profitability of the flight by decreasing demand, the secondary option would increase in value thus protecting the initial investment. Additionally, of course by multi tiering investments this way the banks would increase their fees and revenues for the additional structures. The other advantage that made these so appealing for the larger banks was that they had the greatest ability to create unique leveraging giving them the ability to charge a premium for these bundled packages and increasing their profit line as well as the volume of transactions.
As banks began structuring MBS and CDO SPV's for investors instead of the typical standard yield across the board they tiered the returns and graded the risk into multiple levels called tranches. This structure allowed the securities to generally be graded AAA without much thought and it allowed the banks to restructure entirely new products based on the high yielding higher risk 2nd and 3rd tiers. Eventually banks began creating CDO's squared which consisted entirely of other CDO's while still getting AAA grades. As housing prices increased due to the aggressive nature of lending which was of course due to the high demand for mortgage backed structured finance the bets seemed increasingly less risky as prices continued to climb. This perfect storm if you will was obviously doomed to fail as price climbs on the assets would be capped at whatever amount borrowers were able to continue making mortgage payments. This is why as the housing boom continued into the later stages lenders continued to create loan structures that allowed borrowers to purchase higher priced assets at lower incomes. This structuring allowed the banks to keep running up profits despite the obvious end of the line.
The issue of fraud at the point of structured finance is not just procedural but conceptual as well. To contest that banks clearly didn't account correctly and sold investors a bill of goods on the securitization side is obvious and is being proven in the courts today. What is also starting to be addressed now is the suggestion that banks using these structured finance tools to generate revenue continued to draw homeowners into loans that everyone knew would eventually default and that were clearly overvalued. The train was being floored even though everyone knew the tracks ended quickly up ahead.
From Sub prime to Alt A to Option ARMS retail financing options were created with a clear design to qualify more buyers in order to sell more structured finance at the expense of homeowners and investors worldwide.
As the banks passed through the risk from these obligations to investors they collected their substantial fees and bonuses.
If this weren't enough once retail demand for their mortgage backed securities began to wane instead of reading market conditions they created shell companies to purchase the derivatives that they couldn't sell on the open market thus creating false demand and keeping valuations high by manipulating the market forces. This not only moved product off the books and made the banks more attractive and sound but it of course generated millions in bonuses for the enterprising individuals who managed the false sales.
While structured finance is a useful tool, when it is unregulated the temptation to manipulate and abuse is far too powerful. It's time to take our markets back from those who choose to abuse them and it's time to call them to account for what they've done. Leaving millions of Americans homeless, upside-down, and in debt at the expense of bonuses is not acceptable behavior and even without formal regulation should've been stopped before we ended up here.
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