Sub-Prime Loans and CDOs Have Helped Create the Perfect Storm

You know things are getting bad when the Fed orders mortgage lenders to renegotiate loan payments with homeowners who are at risk of defaulting on their loans. OK, it wasn't a direct order -- the Fed "strongly urged" banks to keep people in their homes. But since the Fed rarely steps in on such matters, analysts say that the Fed's message couldn't be more clear: A large number of foreclosures is not in the banks' best interest; a large number of foreclosed homes sold at auction prices is not in the real estate market's best interest; and a large number of evicted families is definitely not in the economy's best interest.

The housing boom that fueled the broad economy over the past decade has ground to a halt. Homeowners in virtually every demographic are feeling the squeeze. Home sales have dried up, home inventory is at a 9.6-month backlog (the highest in 16 years), foreclosures hit a record high in the second quarter, mortgage delinquencies also hit a record high in Q2 and, most alarming, home prices continue to fall. Standard & Poor's said its nationwide S&P/Case-Shiller Home Price Index fell 3.2 percent in Q2 compared with a year ago.

The Fed's fear is that if foreclosures continue, the real estate market will begin an accelerated downward spiral, forcing more foreclosures and destroying whatever is still propping up the U.S. economy. As usual in matters dealing with the economy, it's a complex situation. A confluence of factors -- a perfect storm, of sorts -- definitely brought the market to where it is now: predatory sub-prime lenders, relaxed lending standards, tighter bankruptcy laws that make it harder for individuals to declare bankruptcy, speculative real estate buying (home flippers) and, one of the biggest drivers, the use of collateralized debt obligations (CDOs) by investors who were seeking big returns.

CDOs made it possible for lenders to take on higher risks because they thought they were slicing and dicing the risk and selling it to investors. Unfortunately, investors rarely understood just what they were buying (and, boy, did they ever buy a lot of CDOs), as this issue's cover story (page 34) examines. Often, investors were blinded by the huge returns that CDOs regularly promised. Financial modeling is only partially to blame for the CDO mess. Portfolio managers, traders and risk managers either ignored warnings, ignored pessimistic data or failed to ask the proper questions required to understand what they were getting into when they invested in these obscure and risky instruments.