Gillian Tett, of the Financial Times, tells the story of the world-wide financial collapse of 2007 and the people and ideas that created it. Banks, the never-ending quest for higher profits and the management of risk are the issues.
Much like other businesses, banks are competitive within their milieu. They each wish to attract more deposits and investors, increase their sales of products and develop and market new products. Managing risk is a key aspect of the industry. Investors weigh the returns on an investment against the risk assumed. An investment of virtual certain return, a US government bond, for instance, can be accepted at a lower rate of return than would be required for something chancier, like common stock in a Canadian mining company. Investors, institutional, corporate and individual, are constantly in search of opportunities for income that match the level of risk that they can accept.
Tett describes the personalities at J.P. Morgan, people like Bill Winters, Blythe Masters and Bill Demchak and their creations, BISTRO (broad index secured trust offering) and other esoteric financial instruments based on credit risk analysis. Their strategies and products were adopted by the rest of the world banking community. In particular, mortgages were bundled into CDOs that were divided into tranches . These were groupings based on evaluations made by ratings agencies. Mortgage-based CDOs consisted of thousands of home mortgages, assembled and then divided into three tranches based on risk. The least risky, the "super-senior" tranches paid off first. If there was a problem, the holders of the most risky tranches, the juniors might not be paid off at all. Many entities were involved in these transactions, the purchaser of the property, the seller, the bank writing the mortgages and then bundling them for sale, the agency rating the tranches, and the investors purchasing them. Ideally, at least in the bank's view, the bank would write many mortgages that would be rated AAA and then these mortgages would be assembled and sold, coming off the bank's books. As time passed, the federal government began requiring, through the Community Re-investment Act, that banks write more and more mortgages for lower income home buyers. Many of these loans did not perform. As time went on, defaults on home mortgages increased in number, investors that had purchased the CDOs didn't receive payments and mortgages that banks had been unable to bundle and sell threatened to drag them into bankruptcy. But, while you or I can be allowed to expire financially, no such fate is permitted in the banking world. We, the taxpayers, must rectify the misdeeds of the government and the banks.