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May 2, 2010

Musical chairs is fun for everyone — until the music stops

Forrest Gump 79ljtg4  

After reading endless stories about the collapse of Wall Street, implosion of the big banks and destruction of the real estate market, I think — think — I can explain what happened in terms a child could understand, which after all is said to be the criterion by which you can judge whether or not you understand something.

Try this on for size:

1. I offer loans to 100 people, without screening them at all. If they can fog a mirror, they get the money.

2. I go to a rating agency and say "Here are my loans, rate them. Remember that if you don't do it in a way that lets me sell them for a profit, I will use another agency to rate stuff in the future."

3. Faced with that ultimatum, the rating agency says, well, OK, out of 100, 20 must be the safest, then there are the next 20, the middle fifth, the fourth group of 20 and the loser bottom 20.

4. So they rate the five tranches: AAA, AA, A, BBB and BB.

5. Now I have five groups of loans to sell to investors. Want something rock solid? No problem, buy my AAA loans. Not as good an interest rate as my BBs but for a little old lady who wants to minimize (note the relativity of this word; i.e. minimized compared to what? But I digress) risk, just the ticket.

And so on and so forth.

Then, when the loans balloon after two years and the borrowers are underwater and lose their jobs and simply walk out the door, the whole thing blows up and everyone goes home crying and empty-handed — except for those fortunate few who realized stuff like this was happening, sold short and bet against the loan makers, and made a fortune.

And that's all I have to say about that.

May 2, 2010 at 02:01 PM | Permalink


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