So, what's the cause of subprime mortgage crisis really?

I think even the bankers themselves do not understand the exotic instrument offered by investment banking such as Goldman (Oo yeah, they are being probed by SEC for possible fraud on this exotic financial instrument). This may explain why highly sophisticated player such as RBS also was being duped by Goldman. Ever heard of CDO (Collateralized Debt Obligation)? This is the culprit of the worse financial crisis since the great depression. So what is CDO and why this has caused so much pain around the world?

What are CDO’S?

Company A sells 10 mortgages to customers with an average built in interest rate of say 10%. Company A which now is collecting from customers monthly annuities on principals and interests of 10%. Company A does not want the annuities; therefore it sells the 10 mortgages to company B as a package. In doing so Company A has accepted to collect cash today from Company B but in doing so accepts a discount on the interest therefore company A now accepts say 7.5% interest instead of the 10% interest original interest.

Analysis

(1) Because company A has no long term interest of keeping the mortgages it is not concerned about the ability of the customer (who ultimately have to pay)to pay keep up with the payments over time.

(2)Company A knows that it is going to sell the individual mortgages as a pooled product therefore it squeezes as much from the customer in higher interest rates and principals (the higher the market value of the underlying asset – the house, relative to its true cost, the more attractive for company A when it tries to sell the pooled mortgages to company B.

Company B is not concerned about the quality of the individual mortgages making up the pooled investment product (CDO) because it, company B looks on the CDO as one product and not a set of discrete mortgages.

Company B needs to edge its bet against the cash it pays out to company A for the annuities it expect to collect. Therefore it takes out insurance from Company C.

Company C does not care about either the individual mortgages or the CDO, rather it looks on the ability of company B to make the fee payments for the insurance.

The problems?

In order for this pyramid to continue un abated, (a) the original customer has to pay above market prices for underlying asset (the house) and (b) the interest rates company A sold the individual mortgages to the customers have to be inherently high for the profit to be shared to each player in the pyramid.

Customer cannot afford to make monthly payments because the customers’ income has not change and the “basket of goods” the customer has to pay for from a fixed income has now become unaffordable. Customer breaks under the pressure and cannot make the monthly payments. What happens, next – the pyramid falls apart.

CDOs are a pyramid scheme setup to take money from the bottom to support the top. Take from first investor to pay second investor (take money from first payer to pay the second person and take from the third to pay the second, etc.,) CDOs are basically a Bernie Madoff scheme.

Walla, in easy, there is no easy way to make a huge profit. As explained above, as complex as it may sound, Goldman is just another thief that masked themselves in the name of banker. What a shame for them to receive such as huge bonuses every year!!