The underlying cause of the current global financial crisis is a system in which there’s little personal responsibility for lending decisions.



Here’s how it all works (or, as we now see, how it doesn’t work).



In the US, some half a million mortgage brokers have been incentivised to “sell” mortgages to potential homebuyers.



They don’t work for the providers of the loans. They are paid commissions for the volume of mortgages they arrange. So, of course, they try to arrange as many mortgages as they can, not minding the consequences.



If the customer wants to borrow more than he or she can really afford, then that’s no problem, thanks to a wonderful innovation called “stated income, stated assets” loans.



These allow US homebuyers to give a personal undertaking that their income is a certain level, even if they don’t provide any proof.



Such loans have been taken out by hundreds of thousands of US citizens who are pay-as-you-earn tax-payers and could therefore have easily provided proof of earnings, had they wanted to do so.



Surprise, surprise: studies have shown “discrepancies” between what such borrowers say they earn and what they actually earn, in 95 per cent of these loans.



These mortgages are now colloquially known as “liars’ loans”.



But liars’ loans are just the extreme manifestation of a US system for generating home loans which is predicated on turning a blind eye to economic reality.



When a borrower has difficulty making repayments on a loan, a mortgage broker would typically encourage them to pay off that loan by taking out a new one for an even greater amount! These are the infamous “rolling loans” which “gather no losses”.



When a loan is rolled over, no one need know that defaults loom – at least not for a while.



Wall Street’s sausage machine



What happens to all these hundreds of billions of dollars in home loans?



Well the paperwork and administration is usually done by specialist home loans companies, such as New Century Financial (which went into bankruptcy protection in the spring).



Then the debt itself goes into a giant mincing and mixing machine on Wall Street operated by the biggest US investment banks, led by Goldman Sachs, Morgan Stanley, Merrill Lynch and the like.



They take all this debt and they process it into asset-backed securities, or bonds.



Note that Goldman, Morgan et al have NO CONNECTION with the borrowers and NO IDEA whether an individual borrower is a good risk or a bad risk.



But they have historic data on default rates.



And this data allows them – or so they claim – to assess whether a bond is a good risk or a poor risk, and therefore to price it for consumption by international investors.



What’s more, verification of the riskiness of a bond is provided, for a fee, by the specialist credit-rating agencies, led by Moody’s and Standard & Poor’s (let’s for now ignore the obvious conflict-of-interest that as the market for these bonds expands, the rating agencies make bigger profits).



There’s a conspicuous problem here. An important part of the US home loans market, the sub-prime mortgages provided to those with poor credit histories, is a young market which has grown like topsy.

Or to put it another way, data gathered from past performance of loans in a small market may not be much of a guide to the future performance of a trillion dollar plus market.



But that hasn’t stopped the big investment banks citing this questionable data to convert sub-prime loans into bonds that they claim are risk-free and which have a so-called triple-A credit rating.



Here’s how they do the clever engineering.



For argument's sake, let’s say that they estimate that as many as one in two home loans will default and that on average there will be a 40 per cent loss on those defaulting loans. That, in turn, gives a maximum risk of 20 per cent losses on a portfolio of these loans.



Bad news? Not for creative investment bankers. Out of this portfolio of low-quality loans, they can create supposedly high quality bonds by putting in place covenants which stipulate that the first 20 per cent of losses would be attributed to one bunch of really poisonous bonds, usually called toxic waste, leaving the rest of the bonds almost as safe as US Treasury bonds (in theory).



Before we move on, it’s probably worth recapping the phoney assumptions made by the investment banks as they create these bonds:



1) That historic data on default rates is useful even though the market has exploded in size

2) That data of any sort is useful even though the system for originating the loans, with mortgage brokers paid by the volume of loans they make, actually encourages fraud.



So far, so disturbing. But it gets worse.



Because the demand for toxic waste isn’t as huge as all that (some purchasers of this poison have suffered horrendous losses), investment banks have looked for ways to slice and dice the toxic waste, to create something almost edible.



They’ve mixed it up with other securities in collateralised debt obligations, which are bonds created out of other bonds – or sometimes they are bonds created out of bonds, that are in turn created out of other bonds (collateralised debt obligations squared, as if you wanted to know).



Even these bonds made of bonds rely to a worrying extent on all that dodgy historic data to determine their risk of default – the credit risk – or the risk that they’ll be vulnerable to interest-rate changes.



But notice too that once the original sub-prime loan is in a collateralised debt obligation, that loan could be one of perhaps a million different loans all mashed together to form this new bond.



What that means is that the eventual purchaser of the collateralised debt obligation has no more idea what’s in that bond than a sap eating a Turkey Twizzler knows what he or she is eating. Little wonder that when there’s a global scare about what may actually be in these bonds, no one wants to touch them.



That said, the investment banker will argue, on the basis of portfolio theory, if you put one load of toxic waste with another seemingly independent load of toxic waste, then the risk of holding them will fall. But for that to be true, each bunch of toxic waste would have to be uncorrelated to the other bunch – and that ain’t necessarily so.



Here’s the bottom line: for the past few years, Wall Street has operated a giant machine for turning mind-boggling amounts of US home loans – which are hugely vulnerable to losses from fraud and the inescapable cycles in interest rates and housing prices – into supposedly risk-free investments for risk-averse investors in Asia, the Middle East and (as it turns out) for Europe’s big banks.



Now if I worked for Goldman Sachs, Morgan Stanley, Merrill Lynch or the other big US investment banks, I might be considering my career options at the moment. It is inconceivable that they will escape unscathed from this debacle. Whatever the financial cost to these banks, which will not be trivial, there will also be significant damage to their reputations.



Europe’s shame



But Europe’s banks are hardly blameless either. If the underlying cause of the global financial crisis is fraud and greed in the US home loans system – from mortgage broker to investment bank – the trigger of the crisis was chronic folly by big international lending banks, notably some in Europe.



I am talking about banks’ use of “conduits” and “structured investment vehicles” (SIVs).



These are special off-balance sheet companies set up by banks for borrowing cheap short-term funds from the money markets in the form of securities known as asset-backed commercial paper.

Now, as their name implies, the commercial paper is secured against asset-backed securities, such as mortgage-backed securities and collateralised debt obligations. According to Citigroup, European conduits held more than $500bn of assets to back commercial paper at the end of March.



But there’s an intrinsic weakness to this funding: commercial paper of short duration has been sold by banks to finance their purchases of long-dated bonds whose assets include those dodgy sub-prime loans to US homeowners.



It’s a classic liquidity mismatch, except when there’s a reliable, active market for such bonds. To reiterate, European banks have been borrowing money that has to be repaid or rolled-over every 90 days to fund their ownership – direct or indirect – of 30-year US home loans.



They did this because they received more from the holdings of asset-backed bonds and collateralised debt obligations than they paid out in interest on the commercial paper. In theory, they made an attractive return.



Here’s the Catch 22: such funding schemes only work while the market has confidence in the value of the collateral backing the commercial paper.



When investors start to have qualms about asset-backed bonds and collateralised debt obligations, banks are squeezed in a vice: short-term funding disappears and there is a collapse in the value of the assets they hold.



So what happened over the past fortnight was a highly predictable – except by the big banks – double whammy.



Lenders to banks refused to repurchase commercial paper when it matured. And the banks that issued that paper faced a funding crisis, because they were unable to sell the collateral or raise new money against it.

Everyone had suddenly woken up to the idea that this allegedly safe collateral of mortgage-backed securities and collateralised debt obligations was the equivalent of a palace built on paper foundations.



That inability of major banks to raise short term finance is why the European Central Bank – and the US Federal Reserve and other central banks – recently pumped tens of billions of pounds of additional liquidity into the banking market at interest rates well below the new market rates (that had risen sharply).



This was subsidised lending by the ECB and the Fed. They have been bailing out silly behaviour by banks that should have known better. State-insured banks had no business engaging in such short-sighted financial engineering, which is a million miles from their core banking operations on behalf of Europe’s consumers and companies.



There is – contra the Economist – a serious moral hazard problem here. The Bank of England, by contrast, would only lend emergency funds to banks at a punitive interest rate, which seems a more prudent way to be the lender of last resort.



What horrors await

On Friday, in an attempt to shore up the US housing market, and by extension the value of all those crappy mortgage-backed bonds, the Fed signalled that interest rates would come down for all of us sooner rather than later.



But that’s to treat the symptoms rather than the disease itself. To avoid a repeat of this kind of crisis, there needs to be a return to lenders taking some responsibility for the loans they make.



Most bankers now think it’s quaint and absurd that once-upon-a time a bank manager actually managed a loan book and even talked to the individuals to whom he or she lent.



Our brave new world – in which a Parisian or Frankfurt bank doesn’t even know whether it’s exposed to the US housing market through its Turkey Twizzler collateralised debt obligations – is neither healthy or sustainable.