How Wall Street Made the Financial Crisis Worse

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Why did all those CDOs issued by Wall Street investment banks between 2005 and 2007 do so poorly? Because the underlying mortgage bonds that went into them were crap. No surprise there. It was the height of the housing bubble, after all, and mortgage bonds backed by lots of crappy mortgages are bound to perform pretty badly.

But did they do especially badly? That is, did banks deliberately put their worst, most toxic bonds into their CDOs, knowing they’d fail but not caring because at least it got them off their books? According to a newly released study, apparently so:

Using a unique database published by the investment firm Pershing Square Capital Management, Faltin-Traeger and Mayer identified the underlying bonds in some 528 ABS CDOs issued between 2005 and 2007, and compared their performance to similar bonds that weren’t included in CDOs.

They found that the bonds in the CDOs performed a lot worse. Even if one holds observable characteristics such as initial ratings and yields constant, the bonds in the CDOs suffered ratings downgrades that were 50 percent to 90 percent more severe. As of June 2010, for example, bonds with initial triple-A ratings had been downgraded by an average 11.84 notches, compared to 5.99 for those not in CDOs. The bonds in the CDOs were also more likely to have been rated by all three major credit-rating firms.

The research provides strong support for the idea that banks — with the help of pliant ratings agencies — put together the CDOs and sold them to investors in a premeditated effort to get rid of some of their most toxic assets, or to provide vehicles for clients who wanted to bet against the worst possible assets. As the authors put it: “It would have been very hard to randomly choose securities with such poor ex-post performance.”

Nearly all mortgage bonds issued between 2005 and 2007 have done badly. But if this study holds up, it’s plain that Wall Street banks deliberately set out to create cleverly-constructed CDOs out of the worst of the worst, not caring that their clients would lose their shirts in the process. That isn’t what caused the financial crash of 2008, but it sure helped make it worse.

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is the first thing despots go after. An unwavering commitment to it is probably what draws you to Mother Jones' journalism. And as we're seeing in the US and the world around, authoritarians seek to poison the discourse and the way we relate to each other because they can't stand people coming together around a shared sense of the truth—it's a huge threat to them.

Which is also a pretty great way to describe Mother Jones' mission: People coming together around the truth to hold power accountable.

And right now, we need to raise about $400,000 from our online readers over the next two months to hit our annual goal and make good on that mission. Read more about the information war we find ourselves in and how people-powered, independent reporting can and must rise to the challenge—and please support our team's truth-telling journalism with a donation if you can right now.

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