So where did the credit problem start?

This is the question I get asked the most. Akin to "who's fault is it?". It's also a pretty hard question to answer. Well, not hard, but it's not a short answer. It started in the mortgage market and it started a couple of years ago. First let's time travel to when things were still good. That would be 3 or 4 years ago and people were buying and selling real estate, mortgages were easy to come by and values only went up.

1. Mortgage Backed Securities

Mortgages are not the simple transactions they used to be. Back in the stone age, you'd go to a bank, fill out an application and hopefully get a loan to help buy the home. The bank would take that loan and either keep it on it's books or sell it to one of the pseudo government agencies (FNMA, FHLMC or GNMA).

And then there a couple of innovations happened that radically changed the playing field. First off, banks started selling their loans to investors, other banks and special purpose vehicles (SPVs). This got rid of the loans, with the associated risk, off of their balance sheets and allowed them to make more loans. From here investment banks started selling pools of loans, then selling structured pools of loans (more about that later) and then all sorts of structures that appealed to every investor.

Now savings and loans and commercial banks (the originators) didn't have to worry about the borrower paying back the loan in 30 years. All they cared about was getting through the next six months and it was someone else's problem. And the investment banks (who securitized the loans) felt comfortable with their risk exposure since they just packaged together the loans and sold them as new asset backed securities (ABS securities). And the buyers of these securities felt secure with their investment because they had the backing of the rating agencies and thought that were being adequately compensated for the risk that they were exposed to.

So everyone was happy. And everyone was making money, so more people got into the business. With more people in the business of making loans, the amount of money made on loan went down, so volume had to go up. The housing market cooperated, prices kept going up, so people used the equity built up in their houses to fix them up or move to a bigger and more expensive houses.

And then lenders started making more aggressive loans to people with worse credit. Since the market was great and defaults were low, there was not much to differentiate good risk from bad risk. So banks could lend money at a much higher rate, but without the same increase in risk. Remember, this is when housing prices just went up. When a borrower got in trouble, more likely than not they could sell their house for more than they owed. The default risk was being masked by a fired up real estate market.

And all these loans got funneled through the system. Investment banks couldn't get deals done with good loans because there wasn't an "arbitrage", or a way to make money, with loans that had low interest rates. So the investment banks started adding riskier (with higher interest rate) loans into the pools.

And then the cracks began to appear. At first it was loans that went bad before they could be securitized. The investment banks had the right to send them back to the originators, who would buy them at cost. The originators always kept a reserve available for a certain percentage of loans going bad, but suddenly that reserve was blown away and the returned loans kept coming. This is when the investment banks started buying up all of the subprime issuers, look at MortgageIT sale to Deutsche Bank for example.

Meanwhile at the investment banks, there was a push to create indexes based on the
ABS securities. These indexes followed a set of 20 ABS securities, picked by committee, that gave a representation of the whole marketplace. Every six months the reference securities were changed so the index referred to current deals rather than old deals. Investors could buy ("long") or sell("short") the index. If you thought that the market was going well, you'd go long. If you thought the market was heading into the sewer, you'd go short.

Lots of people went short. Goldman Sachs made a huge amount of money by going short.

Everyone wants to short the index, hardly anyone wants to go long. Since the index is based on actual bonds, then the implied price of those bonds is also tanking. Now one more step, if you owned a bond that looked just like a bond in the index, then the "implied" price of that bond was also tanking.

So then end of month prices come out. And they are horrible. And the collateral reports on the loans come out, and they are horrible and the rating agency monitoring reports come out and they're horrible too.

And that's the short story.