Slices of the crisis
Over at CNN, there is a very good, layperson-friendly description of the problems with mortgage-backed securities. Using one set of securities as an illustration, the authors delve into the specifics which led to the crisis:
Moody’s and S&P, the rating agencies, aided and abetted the process by giving two-thirds of an issue backed by ultra-risky second mortgages the same safety rating they gave to U.S. Treasury securities. . .
It was an especially hinky offering, because it was backed by second mortgages rather than by traditional first mortgages. A first mortgage rarely becomes completely worthless, because a house is usually worth something.
But often all it takes is a decline of 20% in a home’s value to wipe out a second mortgage, which is typically piled on top of an 80% first mortgage. In our case, borrowers’ stated equity in their homes averaged less than 1% — 0.71%, to be precise. Even that was doubtless overstated because a majority of the mortgages were low-documentation and no-documentation.
Despite these problems, the formulas used by Moody’s and S&P allowed Goldman to market the top three slices of the security — cleverly called A-1, A-2 and A- 3 — as AAA rated. That meant they were supposedly as safe as U.S. Treasury securities.
The CNN piece does a good job of setting out the problem with ratings which disguised the real risk in the securities. (And of course, scholars like Frank Partnoy have been pointing out these problems for a long time.)