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These loans were then distributed to banks such as Wells Fargo (WFC, news, msgs), which in turn sold them to be bundled into securities by brokerages like Bear Stearns (BSC, news, msgs), which in turn repackaged those bundles -- called mortgage-backed securities -- into a new class of financial instruments known as "structured finance" vehicles. These instruments, in some cases known as "collateralized debt obligations," or CDOs, basically smooshed thousands of very high and very low credit risks into a single new income-producing package that could be dolled up enough with marketing, duct tape and pixie dust to earn high marks from credit-rating agencies like Moody's (MCO, news, msgs).
In a global game of hot potato, these income-generating time bombs were then sold to hundreds of hedge-, pension- and money-market-fund managers in Asia, Europe, the Middle East and the United States who had vast pools of money to invest and wanted more yield than they could get from Treasury bills.
I know it sounds crazy, but these CDOs were bought by supposedly sophisticated customers who thought they knew what they were getting, but really had no bloody clue. It didn't really matter for the longest time, when U.S. home prices and incomes were rising and everyone could pay their mortgages. But now that foreclosure rates in parts of California, Florida, Ohio and Michigan are double last year's, home buyers are walking away from their investments. Money has stopped flowing into the humble mortgages underlying so many of these supposedly bulletproof instruments -- undermining the whole house of cards.
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Last week, the crisis that led the Fed to act came from the trillion-dollar market for a type of short-term debt known as commercial paper. Buyers of these instruments had suddenly determined that toxic CDOs were being used as collateral in supposedly safe CP, and collectively backed away from the table in a stunning rebuke of issuers.
Said veteran banking analyst Richard Bove in a note to his institutional clients at Punk, Ziegel: The lenders realized "how unbelievably foolish they had been in throwing money after deals that they did not understand; instruments that they had not underwritten; and securities that provided no interest-rate protection against risk."
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The Fed's passion for ratesMSN Strategy Lab expert Ken Kam discusses how successful the Federal Reserve is at manipulating rates.
Cranking up the printing presses
The world cannot run without free-flowing commercial paper, so in order to prevent total worldwide economic collapse, European central banks and the Fed printed an astonishing amount of money -- almost half a trillion bucks -- to flood the zone. Then Bernanke topped it off with the discount-rate cut.What's wrong with this? It perpetuates the cycle of blamelessness and only prolongs an inevitable splat. As Bove points out, homeowners years ago learned to roll over credit card debt into home-equity loans. Then the rise of negative-amortization home loans allowed people to buy homes with no down payments. Next came "evergreen" loans in which borrowers pay interest but little principal. Then came loans in which lenders actually funded interest costs. More recently have come so-called "covenant light" loans in which borrowers are often allowed to meet their obligations by automatically receiving new loans for the amount of the payment.
Continued: Potential for disaster
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