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CNBC Special Report: House of Cards

In a special two-hour report, CNBC's David Faber takes an in-depth look at the causes of the ongoing collapse of the housing industry.
/ Source: CNBC

In 2004, in the midst of the housing boom, President George Bush had a chance to do a little bragging in his State of the Union Address.

“This economy is strong and growing stronger," he said, to applause in the House chamber. "New home construction (is at) the highest in almost 20 years. Homeownership rates (are at) the highest ever.”

Just one month later, then-Federal Reserve Chairman Alan Greenspan encouraged the mortgage industry to come up with new kinds of loans — so even more people could buy homes.

“American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage,” Greenspan recommended in a speech to the Credit Union National Association.

It was music to the ears of Wall Street bankers like Michael Francis. His business was to pool mortgages and sell them to investors who would then get the monthly payments those mortgages produced. The more mortgages lenders provided to homebuyers, the more “product” Francis would have to sell. (Francis asked CNBC not to disclose his employer's name.)

But Francis said there was a downside to Chairman Greenspan’s encouragement to mortgage lenders.

“The unfortunate thing that grew out of that was a program that was a very inappropriate loan program for a lot of people that took it," he said. " And it became extremely popular.”

The program had a name only a banker could love: “the pay option negative amortization adjustable rate mortgage.” It was designed to help first-time homebuyers who couldn’t actually afford the cost of the loan. Those homebuyers would have the option to pay only part of the interest they owed each month. The unpaid interest was added to the total amount of the mortgage. As a result, the mortgage balance increased; instead of the mortgage being paid down, it was getting bigger.

Even this so-called “negative amortization” loan seemed to be acceptable to investors — as long as home prices continued to go up. The mantra on Wall Street was that home prices nationwide had not gone down in a single year since the great depression. That’s what kept Michael Francis going, even if he was starting to have doubts.

“It didn’t feel right,” he said. “Not every loan anyway. We were allowing people to leverage their homes a little bit too much.”

It may have given Michael Francis pause, but it didn’t matter to most other Wall Street bankers as long as they could pool together thousands of these mortgages, carve them up and profitably sell them as securities.

The key to getting investors to buy those mortgage-backed securities was to get them stamped with a seal of approval. Big institutions like police retirement funds and universities would only invest if the investment rating agencies — Moody’s, Standard & Poor’s, and Fitch — gave the securities an “investment grade” rating. “Investment grade” can range from the safest triple A-rated investments to the lower triple B-rated investments. Because a triple A security is safer, it pays less than a riskier triple B.

Ann Rutledge was one of those who rated securities for Moody’s during the housing boom. At that time, when home prices surged and virtually no borrowers defaulted, she said, triple B-rated securities from mortgages looked as good as the safe triple As.

“The class B is suddenly much safer than it used to be,” she said. “And over time it becomes like a triple A security. Eventually, the market gets smart and says, ‘let's lower the requirements for triple A.’”

But the credit rating agencies also had an incentive to award a security the best possible rating. That’s because they were paid for their appraisals by the very banks that issued the securities.

Joseph Mason, an expert on the rating agencies who teaches finance at Wharton and at Louisiana State University, points out that awarding good ratings became a huge engine for earnings at the agencies. As a result, he says, the agencies had a concern that if they didn’t give a security the desired rating, they would lose the business of the investment bank that had hired them to rate a new issue of securities.

“It's what we call a repeated game,” Mason said. “I'm going take care of you because I'd like to see you come back. “

Moody’s officials respond that the company “properly manages the potential for conflicts of interest and has added new safeguards that further address those conflicts” since the collapse of the housing market.

In any case, revenues for the rating agencies shot up during the housing boom – as did their stock prices as they competed against one another for the banks’ business.

Ann Rutledge says that, during the boom, the business got more competitive.

“You just wanted to make sure you had as much business or more than the next rating agency,” she said.

Rutledge believes the competition led to a distortion of rating standards.

“The problem is, if you are the only person who knows how these standards work… if investors aren’t paying attention and investment banks are only comparing what they can get if they go to you versus the next ratings agency, nobody’s paying attention,” she said.

The result of that failure of attention was a massive failure to accurately judge the risks of mortgage-backed securities. In time, that led to the collapse of the housing market. And that, in turn, led to a situation which everyone around the globe is now paying attention to: the current global economic collapse.