In the good old days, if you wanted to buy a house, you went to your local bank, had a talk with your local banker, filled out some paperwork and applied for a mortgage. The banker determined if you qualified, that is, if your income made it possible to comfortably make your mortgage payments, if you had enough money for a down payment, and then loaned you the money to buy the house. You made monthly payments to the bank that included principal plus interest for 30 years. 
At that time your relationship with the bank ended, insofar as the mortgage was concerned, the bank was happy because it had made money on the loan, you were happy because you owned the house outright and could live mortgage and rent free in your Golden Years and all was copacetic. These transactions were regulated by the government primarily by means of the Glass-Steagall Act which erected a barrier between investment and commercial banking. This was a reaction to the stock market crash of 1929 and the Great Depression. On November 12, 1999, President Bill Clinton signed into law the Gramm-Leach-Bliley Act, which repealed the Glass-Steagall Act of 1933. Then it was off to the races for the housing bubble.
Instead of your local banker, who had a personal relationship with you, loaning you the money, the "loan originator," a mortgage company such as Ditech or Countrywide, immediately sold your loan to a Wall Street investment banking firm such as Goldman Sachs or Merrill Lynch. These companies assembled portfolios of mortgages from all over in a pool called Collateralized Debt Obligations (CDO)and then "securitized" them which means they sliced them and diced them, packaged them up and sold them off to investors. Cleverly, they packaged these Mortgage Backed Securities (MBS) in such a way as to be able to give different investors customized slices or tranches (French for slice). So if you wanted a low risk, low return tranche, they sold you that. If you wanted a high risk, high return tranche, they had a deal for you too. They had everything from AAA rated tranches all the way down to junk tranches. The problem was, unbeknownst to Wall Street, all the tranches were really junk because of the way the loans were originated. Instead of your banker carefully poring over your paperwork (as in the Ditech commercials) and making a determination whether or not you qualified for a loan, as far as the mortgage companies were concerned, everyone qualified because they based the loan on "stated income." You could be working at Wal-Mart for minimum wage but you walk into the mortgage company and simply state or tell them the whopper that you are making $100,000 a year and, guess what, you qualify for a "jumbo" mortgage.
And as housing prices were bid up by the increased demand resulting from easily available mortgage money, more and more houses required a jumbo.
The mortage company had the incentive to grant as many loans as possible because they immediately sold them to Wall Street so their "exposure" to the loan was nil. At the same time, they were making a ton of money on commissions. Like any good broker they were "churning" mortgages. They were offering all kinds of "creative" loan products: nothing down, no problem. You want to lower your payments and take equity out of your house, in other words, use your house like an ATM machine, no problems! So in reality all the tranches were really junk and you had no relationship with Goldman Sachs or whoever it was that bought your loan and tons of others, repackaged them and sold them off to investors all over the world. Any particular investor might own a slice of your house, a slice of someone else's house somewhere across the country and so on, all neatly packaged into a AAA rated bond. Credit rating agencies such as Standard and Poor's went along with this charade so that investors really believed the tranches they were buying were AAA rather than junk.
So all the investors were depending on Mortgage Backed Securities which means that the revenue streams from all the collateralized mortgage payments from John and Sally Homeowners formed a pool of money from which the investors were paid. But then what happens when the housing market turns down or when the homeowners' adjustable rate mortgages reset to higher interest levels and all of a sudden their payments go through the roof or both! Pretty soon John and Sally get behind in their payments or stop making their payments altogether. In other words they default. Eventually their house gets foreclosed on. From an investment banker's point off view, it becomes a non-performing asset, a revenue stream that he was counting on to combine with other trickles and then divide up to pay off the tranches, a stream that has dried up. And at this point it's pretty difficult to even figure out who actually owns the house: the bank, the mortgage company, the "loan originator," Goldman Sachs, the investors with their tranches??? In the old days it was the bank, of course!
John and Sally can't sell their house because all of a sudden it's a buyer's market. They can't get their equity out because the market has dipped and they have refinanced all the equity out of it anyway. They can't refinance because all of a sudden "stated income" doesn't make it any more; credit standards are tighter. Everyone's in a bind. That's why Merrill Lynch and Citibank have had to "write down" billions of dollars. They need to pay their investors that bought their tranches even though they're not getting revenues from mortgages they were counting on. All of a sudden, you've got a mess. But wait, it's even not as simple as that. There's more. The situation is even more complicated because we still haven't taken into account the ABS index, (Asset Backed Security index). This allows investors to "gain broad exposure to the subprime market without holding the actual asset-backed securities." They can "go short" or "go long," in other words, they can place bets on how the sub-prime market will do. Those who have shorted the market, obviously, have done very well.
"We expect ABX to build liquidity and transparency in the synthetic asset-backed market, attracting global investors that seek exposure to this asset class, both on the buy-side and sell-side," stated Kevin Gould, Executive Vice President and Head of Data Products and Analytics at Markit.
In order to qualify for index selection, an issuer must have rated bonds for each of the AAA, AA, A, BBB, and BBB- categories. One bond from each deal will be referenced in each sub-index, and bonds must be rated by Moody's and S&P, with the lesser of the two ratings applying. The five sub-indices are based on the rating of the reference obligations which are equally weighted at index launch. Subsequent weightings may change based on the performance of loans in the underlying pools.
The minimum deal size is $500 million, and each tranche referenced must have a weighted average life of between four and six years (except for the AAA tranche, which must have a weighted average life greater than five years). No more than four deals can be selected from the same originator, and no more than six deals can be selected with the same master servicer.
Unlike the corporate CDS indices, the ABX contract component trades are reference obligation-specific, rather than entity-specific. Also, unlike corporate bonds which are bullet maturity, ABS bonds amortize at variable rates over the life of the instrument. An ISDA Pay-As-You-Go (PAUG) template, the standard for U.S. residential mortgage-backed securities, references each bond. Traditional credit events, as they apply to the PAUG contract, do not form part of the index contract. Hence all settlements will occur through the Floating Payment mechanism covering interest shortfalls, principal shortfalls and writedowns.
This is all pretty arcane, esoteric and far removed from the simple reality of John and Sally Homeowner who just want a place to raise their family and build up their life savings as the equity in their home continues to rise. Is there something to be said for simplicity? Until they fell for the advertising pitches from mortgage companies aggressively marketing re-fi's which allowed them to use their home as an ATM machine, they could have rolled with the tide as the market for homes went up or went down, locked into their constant payments on a 30 year mortgage. But alas, they fell for the pitch. And they are not innocent victims either. Their own greed and lust for consumer goods is at least partly to blame. As home prices went through the roof fueled by all the readily available mortgage money freely given with nothing more than "stated income," taxi drivers starting flipping houses. Now the problem is housing prices have been bid up so high that nobody except the rich can afford to buy them. Instead of living in a mortgage free house in their old age, John and Sally have been effectively priced out of the housing market altogether. Even hedge funds, whose investors greedily "sought exposure" to the sub-prime market, have gone over the edge of the bubble as unsustainable growth has indeed become unsustainable. First the stock market bubble of 2000, now the housing bubble, what's next?
Is it really worth it? Free market capitalists think so. No financial instrument is too sophisticated or too complicated for them. Should the government regulate this mess? Heck, no. That's why Hedge Funds were created in the first place. Guess what? Unlike mutual funds, they're unregulated. So John and Sally are suckers and sophisticated investors who shorted the ABS index are the gainers. Devil take the hindermost! That's Capitalism for you. Oh, by the way, Goldman Sachs didn't do too bad because it shorted its own mortgage backed securities via the ABD index. So while its customers were getting stomped, Goldman Sachs came out smelling like a rose!
