"The risk models turned out to be quite flawed and should not have been given the weight they received."
What were the initial seeds of the 2008 financial crisis?
It's a big question, but I think it really starts with the origins of subprime lending, which is a form of lending that is intended to allow people who can't afford a 20 percent down payment and a normal, "prime" mortgage, to own a house. That sounds like a worthy goal, but over time it became horribly distorted. Eventually it became a means through which mortgage companies that specialized in subprime mortgages could just hand out loans to anyone with a pulse, take the fees and send those mortgages off to Wall Street.
Wall Street then bundled those loans into what's known as securities, which are basically bonds that are stuffed with thousands of these loans. That's what eventually becomes known as "toxic assets." The reason they were toxic is because they were mortgages that were bound to eventually default. Once the housing bubble burst, home prices declined, people were no longer able to refinance their homes, and so they defaulted in huge, unprecedented numbers. When that started happening, all of the banks that held these securities on their books were suddenly in a lot of trouble. That's really what brought us to the brink of disaster.
And why would the mortgage companies want to back those subprime mortgages?
Nobody had any skin in the game. Instead of a bank holding a loan on its own books, it would sell the loan to someone else and get a fee. They sold more and more loans and got more and more fees because if the person defaulted, it wouldn't really be their problem. They didn't care if the original borrower could pay it back or not. Similarly, Wall Street didn't really care either, because they were selling these bonds to investors. You would think the investors would care, but because these bonds were somehow rated AAA, everyone thought they were safe.
Why didn't the rating agencies do a better job of rating these products accurately?
There are two reasons for that. First, the entire system was hooked on these very mathematical risk models. The ratings agencies relied on these models to tell them that the chance of default was minimal, therefore they could rate the securities AAA. But the risk models turned out to be quite flawed and should not have been given the weight they received. The less noble reason is that the rating agencies made huge kinds of money rating these derivatives and bonds. It was a pot of gold for them and once they discovered how much money they could make doing this, there was no turning back.
In the book you wrote with Bethany McLean about the lead up to the crisis, 'All the Devils Are Here,' you start with the securitization of mortgages at Salomon Brothers in the '80s. What was new about what they were doing?
When securitization originally came about, it did two really powerful things. Firstly, it took what had previously been a very local means of finance, the local mortgage lender, and effectively nationalized it. The second thing it did, by turning these loans into something investors could buy, was free up lots of capital so that banks could make more loans. And the fact that these loans were all bundled into something else was itself an innovation that had never been done before. There hadn't even been something called a "mortgage desk" when this first came about. Over the course of time, mortgages became one of the most popular instruments that Wall Street would end up trading.