Crask Explainer 4: The Market for Risk

Can we talk about the old days? Back in the old days, when a bank wrote a mortgage, the bank took a risk. If you didn't make your payments, the bank had to contend with the expensive process of taking your house and reselling it at auction. To avoid that result, the bank did its best to determine your ability and willingness to pay it back.

No longer. Our new world, created by Fannie Mae and apotheosized by Lehman Brothers and Bear Stearns, is a place where consequences become wholly untethered from actions. The risk formerly carried by your mortgage bank is titrated into a kind of default-risk toxic sludge and sold to AIG.

This then, is a brief explanation of how the geniuses on Wall Street unglued the risk from mortgage banking. First, investment banks bought the mortgage portfolios of mortgage banks. Then, the investment banks organized special-purpose corporations (SPVs) and sold the mortgages to them. With the mortgages, the SPVs also acquired the associated default risk.

The SPVs were created as mortgage-backed security conduits (for more on mortgage-backed securities see this post). The SPV-issued securities were multi-tiered, with some tiers backed by riskier mortgages than others. The securities backed by the most stable mortgages were sold to the public. The worst went back to the investment bank; the default risk that started with the mortgage bank was distilled and acquired by the investment bank.

To protect itself from these risky securities, the investment bank bought default insurance. Because this insurance swapped default risk for insurance premiums, it was called a credit default swap. Who was the largest insurer? AIG. Thus, the default risk that originated when you borrowed money to buy a house was shifted onto the policyholders of AIG, and finally, to the taxpayers.