Letting others take the loss

The bubble bursts

Loans flop and banks let others pay

Prices fall after marketplace opens
At first, most trading in Mortgage Backed Securities (MBSs) was done behind closed doors, between two parts. As bonuses were depending on fees and fees were depending on sales volume, the banks were more interested in big volumes then in making good deals for their customers.
There was no real market price, one firm sold to another, this in turn sold to a third and so on, raising the price, creating a fictitious value without any regards to any underlying value. Each time, the seller recorded a fictitious profit; each time, the he got a real fee. In 2006, the banks opened a market place for MBSs and with this followed a more realistic appraisal. The prices fell, first slowly then faster; more and more loans were defaulting; at the end of 2007, the big MBS indexes had fallen by 80%. note

Investors, not banks, pay for bad loans
The banks securitizing the mortgages did not care much about the quality, only about the profits from securitization. The losers were not the banks, the losers were the investors; rich individuals, pension funds, communities. Several of the biggest banks were fully aware that the mortgages they were packaging were littered with fraud. note

Selling most likely to fail
The big players knew that MBSs were grotesquely inflated, only staying up because investors were kept in the dark. Goldman Sachs was early to realize that the bubble was about to burst. So they began "shorting" CDOs, basically betting that they would fail. To maximize profits, they made a selection of CDOs "most likely to fail - quickly". This selection was then sold to their customers as independently picked with the investor's interest at heart. Citigroup was doing the same thing. Selling crappy CDOs as independently selected and then going short against them. link link link

Too much risk, AIG won't insure any more
Especially Merrill was aggressive on dealing in subprime loans and CDOs. In 2002 they created hardly any; four years later they were biggest in the world. When they could not get assets enough, they created synthetic CDOs with even higher fees. In 2006 they reported record profits and the employees got more than $5 billion in bonuses.
To insure the synthetic CDOs, AIG issued CDSs. At first, the CDOs were seen as next to no risk so AIG issued many more CDSs than they could back; this meant that the insurance might be worthless. In 2005 the risks were deemed too big and AIG no longer wanted to insure Merrill's securities. note

FHA asked to take over bad loans
When the securities were getting worse, the banks searched for ways to reduce their losses. The Federal Housing Administration, once a conservative and successful insurer for lenders, was asked by bankers to insure negligent loans, with bankers getting away for free. It would be like buying an insurance after you crashed your car. link

Most bad loans to investors and F&F
Some banks understood what was going on; CDOs were seen as crap and customers as dupes. Some managed to get rid of most of what they had before the crash; much was unloaded to the taxpayers via Fanny and Freddie. Some banks were too late, they were left sitting with a lot of bad securities. note

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