Okay folks, we all know we're in this mess because of mortgage-backed securities, right? Good. So what the heck is a mortgage-backed security, how did they become such a problem?
Mortgage-backed securities are a specific type of Collateralized Debt Obligation (or CDO). There are other kinds of CDOs out there, but they all take the same basic form, so let's illustrate with mortgages, 'cause that's what's in our epicenter right now anyway.
In a traditional universe, if I need a mortgage, say for $100,000, I go to my bank. The bank takes $100,000 from other folk's savings accounts and gives it to me. Over the next thirty years, I pay that back with interest, and the bank in turn pays interest to the folks with savings accounts (although they pay less than they take in, thereby resulting in the bank's profit). There's often more to it than that, but that's the general idea.
Now, if I default on my mortgage (i.e. I don't pay), the bank forecloses on my house, sells it off, and hopefully gets enough on that sale to cover however much of the loan I hadn't paid off. If they don't, they have a loss.
With a CDO, the bank takes a bunch of those mortgages (let's say 100 of them), and bundles them up into a corporate entity that holds them. That corporate entity sells bonds to investors (bonds == corporate loan borrowing). The people who took out the mortgages make their monthly payments, those payments are aggregated together and then chopped up and handed out to the folks who bought the bonds. (Of course, the bank skims some money off in between...it's good to be the middleman.)
What does the bank get out of this? An easy way to raise the money to fund more mortgages.
What does the investor get? An easy way to get a steady income while mitigating the risk because of the assumption that while one of those 100 mortgages may go bad, what are the chances of them all failing? (Insert hysterical laughter and 20-20 hindsight here.)
Now, the folks who play these games aren't entirely foolish. They know that there are risks involved. In fact, they built very complicated mathematical models to figure out the risks involved, and then bought insurance for the bonds just in case. This insurance helped get the bonds a AAA rating (the best) so they didn't look like risky investments at all.
Go a step further, now. The scenario I just described is oversimplified even compared to the simplest of CDOs. Many of them got sliced and diced again and again, fed into mutual funds, and so on. Which means it got very very very difficult to actually assess the risk involved. But people didn't care 'cause they were making money hand over fist.
Until the foreclosures started hitting in droves. Oops.
You see, these bonds were used to generate funds for sub-prime loans. These are loans for folks who's credit is shaky enough that they don't qualify for regular loans. Most of them were adjustable rate mortgages, many had "teaser" rates so that the initial payments were low enough that the person could pay, but the real payment kicked them in the butt. Folks fell behind. Went into default. Lost their house.
Eventually, enough houses got thrown onto the market that instead of climbing, house prices started falling. Now you've got folks who are upside-down on their loan (i.e. they owe more than their house is worth) and no hope of refinancing. The foreclosures cascade.
Now the folks on Wall Street start to look at these CDOs they have, and wonder how many foreclosures really are buried in them. They look and realized they really can't tell. And if there is one thing that will turn the bowels of a Wall St financier to water, it's uncertainty. Losing money is one thing. Not knowing how much you just lost...that's, well, unthinkable.
These are folks who had been trading around these CDOs more or less as cash. But now they don't want to buy them, because nobody knows if any one of them is a turd wrapped in pretty paper or not. Which means there is suddenly no market for this stuff. Which makes things sticky when the accounting rules say you have to value things at their current market price.
Which leads us to where we are now, where banks won't lend money to each other because the stuff they'd normally use as collateral for the loans (these CDOs and such) have essentially no value. At least not a value that can be trusted.
So that's the story of mortgage-backed securities, or at least as much of it as I can capture in one sitting.