Investors Take A Gamble They Believe Is Safe

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Investors from Wall Street to Warsaw bought the securities with little or no knowledge they contained pieces of toxic loans made to high-risk borrowers--- loans that could default on homes that could go into foreclosure.

Ratings Agencies Provide Misleading Grades

Why didn't investors at home and abroad know about the dangers of these securities?  Because credit rating agencies gave them high grades, in many cases the valuable and respected AAA rating.

AIG Builds Risky Insurance Business

And, just in case something did go wrong with those securities, some investors bought insurance policies called Credit Default Swaps, issued by companies such as AIG.  A CDS guaranteed an investor would not lose money, even on the riskiest asset, assuring a payment even if the underlying security defaulted.  And by 2005, with expectations that home values would continue rising and homeowners would continue making their mortgage payments, AIG believed the CDS business was fail-safe.

International Appetite Grows For Mortgage Securities

Crap Into AAA

As demand by consumers for mortgages continued to grow, so did demand by institutional investors for mortgage-backed securities. The most common form: Collateralized Debt Obligations, known as CDOs. Flush with billions, hedge funds and sovereign wealth funds gobbled up these CDOs. But the AAA credit ratings that helped lure investors were deceiving. They masked the underlying risk of those securitized subprime mortgages. One former Moody's analyst says it was easy to "turn crap into Triple A." 

Reward Turns Into Risk

Rating Agencies

Several years later, in July 2007, Standard & Poor's would downgrade billions in mortgage backed securities. In announcing the changes, S&P admitted it misjudged the risk of those products.

Fannie And Freddie Join The Party

Prior to the downgrade and the cloud that eventually hung over subprime securities, even Fannie Mae and Freddie Mac, once known for buying the safest kind of mortgages, got into the game. Following an accounting scandal that temporarily slowed down their mortgage-buying business between 2003-2005, Fannie and Freddie felt compelled to compete with Wall Street for a share of all those subprime loans being sold by their originators. So Fannie and Freddie lowered their standards, just as the lenders had done. They began buying lesser-quality mortgages, including subprime loans, exactly the kind they avoided years earlier.

Uncle Sam’s Subprime Surprise

The federal government, which created and supported Fannie and Freddie, had now gone into the subprime mortgage business. And eventually, taxpayers would pay a severe price.

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