A very short history of how we got here:
All of the turmoil in the CDO, hedge fund, and subprime space has come about due to a very simple reason: An inordinate number of recent home buyers have been defaulting on their mortgages.
The why of this is rather simple: These are the folks who historically have not been home owners due to their debt obligations, low income, and/or poor credit. In the past, they were known as renters.
The ultra-low rates that Easy Al put into place when he dropped the Fed Funds to 1% started an entire chain reaction of events: If high rates keep home prices down, well you can guess what ultra-low rates do. Home prices rose due to the lower monthly carrying costs, and we were off to the races..
But the boom begat a feeding frenzy, and corruption soon followed. The appraisers faked values to get loans approved (making a 100% LTV look like a 80%). Mortgage brokers quickly learned how to get nearly anyone approved through no doc/no income check loans, AKA liar loans. A bunch-o-new mortgage products came out — Interest only ARMs, LIBOR based, etc. I am not sure what legitimate purposes these very profitable products served, but we know what they accomplished: They got people into homes THEY COULD NOT AFFORD.
Hence, when rates ticked up, when prices stopped rising, when people could no longer bootstrap paying their mortgages by taking out more home equity loans, the foreclosure rate began to rise.
When this happens, the RMBS/CDOs that have been sliced and diced and resold by iBanks to funds start to devalue. Since so many of these funds use huge leverage, the problem gets magnified.
Hence, the recent Bear Stearns and other fund problems.
To put this into a geographic context, here is where the foreclosures are coming from:
WSJ, July 19, 2007
The Bear Facts: Mortgage Woes Are Apt to Worsen
RANDALL W. FORSYTH
Barron’s JULY 18, 2007 10:45 a.m. EDT