"Shadow banking" issuers of mortgage-backed securities. One of the principal perpetrators in the FCIC's account are the huge investment firms such as Goldman Sachs and Lehman Brothers that chopped up mortgages and recombined them into mortgage-backed securities, which they then sold to investors. One of their favorite tricks was to package highly rated prime mortgages with riskier subprime loans to create collateralized debt obligations which would then get higher ratings from ratings agencies, the report says.
When the housing bubble burst, no one was quite sure how much these packaged instruments were worth because they contained so many different loans of varying qualities. Those investors and institutions that had bought the investments, assuming they were safe, were suddenly unable to sell them. Because many had invested with borrowed dollars, they took major -- sometimes fatal -- losses.
The toxicity of these investments eventually caught up with many bundlers of mortgage-backed securities. While they only held on to a tiny percentage of the securities they created, they were producing them at such high volume that when the market dropped, they were stuck with billions of dollars' worth of bad mortgages in the pipeline, as well as "super senior" tranches of MBS with interest rates too unattractive to sell, the report says.
Many bundlers of these mortgage securities, so heavily leveraged they had no hope of covering their bets, simply imploded. Others were sold in government-sponsored fire sales. Unfortunately, because bundlers of mortgage-backed securities were often investing with borrowed money, sometimes holding only $1 for every $40 they invested, the bondholders and investors who had loaned them capital were also wiped out, pushing the global markets into panic.
Issuers of credit default swaps. Bundlers and investors of mortgage-backed securities had some idea of the massive risks they were taking, so they turned to buying insurance products called credit-default swaps that would pay out in the event borrowers defaulted on the mortgages underlying the securities.
But the companies that sold collateralized debt securities underestimated the risk they posed, the report says. When the housing bubble burst and the investors in mortgage-backed securities came to collect, these insurers, such as AIG, did not have enough cash on hand to cover the losses.
Investors that had been counting on this insurance were no longer certain they could count on it, further destabilizing the market and forcing the federal government to bail out AIG, one of the largest sellers of collateralized debt securities, with $182 billion of taxpayer funds.