2008 in Review - Wall-E World (July)

I always wanted to be a political cartoonist, but I can't draw a straight line with a ruler.  Still my choice for best movie of 2008 (though I have a couple left to see), Wall-E provided my favorite editorial cartoon of the year - which I had to write instead.

Listening to an explanation of how sub-prime mortgages spun out of control, I found myself thinking about Wall-E.  What does a futuristic trash-compactor have to do with the credit meltdown?

In the old days - you know, the early 90s - lenders paid attention to the credit-worthiness of the borrowers they were loaning money to.  Historically, loans were held by the lender, only occasionally being assigned to another financing company who then held onto the loan.  As a result, there was very little “sub-prime” lending, because lenders didn’t want the risks caused by loans going bad.

But in the middle 90s, a new trend began to emerge.  A market was created for gathering loans from lenders and converting them into a different product – Collateralized Debt Obligations, among others.  Now the lender no longer held onto the loan for the life of the borrower, but sold it off.  The risk of the loan going bad passed out of the hands of the lender and onto the next holder.  Make a loan, make an origination fee on the loan, sell the loan and off-load the risk.  Pretty easy to see how volume lending and lax lending standards became common-place.

The investment house - Morgan Bear Wall-E, we’ll call it - would gather up a bunch of loans from all over the country and “package” them into the new product.  MBW would scoop up an armload of loans and compress it into a tidy cube, which became a building block.  Initially, these blocks were still very solid, because most of the loans being “bundled” were of good quality.  The less-attractive loans, the ones made of rubbish, were safely compacted into a tranche with enough solid loans that the whole block was stable.

The business of packaging loans, though, started heating up.  And so the original concept of packaging a few weak loans in with the rest got pushed aside in the demand for more loans to package.  Over time, what got scooped up wasn’t important. What was important was there was enough to scoop, and so more and more of the loans became the less-solid, rubbish kind –  sub-prime loans and stated-income loans and wildly optimistic adjustable-rate, teaser-rate and interest-only loans.  Like Wall-E’s earth, more and more rubbish piled up with the valuable stuff.  So more and more of what got scooped and compacted was rubbish.  But since MBW was less and less concerned about what was in each little cube, they kept scooping and packaging. 

Having taken individual loans and popped them into a little cube, they were now considered securities.  They looked like the earlier-generation of cubes, but there was absolutely no way of determining the credit-worthiness of the tightly-packed debt that made up the security.  In stepped the bond-rating agencies.  They were being paid to evaluate the cubes, but there was no history to support their ratings - and there was pressure from MBW, who paid the fee, to have the cubes rated as good, solid building blocks.  So they were.  

What was once a teaser-rate, interest-only loan, given to a borrower with barely enough income to pay the interest at the teaser rate, and secured by a house with no equity, was now transformed into an investment-grade security.  Loans that no reasonable investor would buy standing alone were given the illusion of stability by being packed into a tight little cube of other loans.  

Morgan Bear Wall-E would then deposit the newest block next to, on top of, and all around other blocks - their own and cubes made by others - until a nice, tall building was finished.  A nice, tall building made of rubbish.  Morgan Bear Wall-E would then find a buyer for the building.  The building had been given a seal of approval as being made of AAA-rated securities, and there were plenty of buyers. 

For a time, it worked.  After all, some of what was being scooped up and packaged was fairly solid building material.  Even the really unappealing loans don’t all go into default.  They still haven’t.  But as can be predicted when scooping whatever happens to be around in the trash heap, some of what got compacted into cubes wasn’t nice solid steel-type debris, but was more like compost.  Some of these loans were fraudulent on some level.  Some were merely wildly optimistic about the real estate market.  But they were not nearly so solid after all.  And so some of the cubes packaged by Morgan Bear Wall-E started breaking down.

The cycle of packaging more and more loans into investments almost assured the result.  As more questionable loans were made, MBW still snapped them up to make sure there was enough volume, and so more cubes were destined to be made of less than solid material.  When some of the cubes start to give way, it doesn’t matter that half of the cubes are made of sturdier stuff, the building is coming down.  With irony which should be remembered in the future, what was thought to be a means of reducing risk perversely became the reason that the market for real securities and for good home loans collapsed.  

There’s the old adage that says “one man’s trash is another man’s treasure.”  Somehow, everyone involved in the mortgage industry unanimously declared that there was no more trash, merely recycled treasure.  Pixar probably didn’t see this particular parable coming, but I can’t hear about the credit crunch, the crisis in consumer confidence or the rise in foreclosures without seeing wobbly buildings teetering on rotting foundations - and a plucky little robot, scooping up all those questionable loans and then popping out tidy little blocks of marketable securities.  Every economic collapse should have an iconic action figure.