Remember the original TARP? Hank Paulson asked Congress for +$700 Billion to buy "toxic" bonds. Then, after only a couple of days, he said he couldn't identify toxic bonds so he diverted the money to other uses. What I could never understand is why he couldn't identify the bad bonds. All he had to do was look at the S&P and Moody's ratings. BBB rated bonds were mostly likely toxic. End of story. How easy could that be?
Well, I found the answer to my question in Michael Lewis's book, The Big Short. As I understand Michael, here is what happened. Wall Street banks took low risk mortgages (substantial down payment, good income, good credit, etc.) which should be rated AAA and mixed them with high risk mortgages (no down payment, no verified income, poor credit, etc.) which should have been rated BBB, and every kind in between. Then they talked the rating agencies into rating these new products AAA.
Next, they stripped all the BBB mortgages out of the original bonds and created new bonds stuffed with BBB mortgages. They convinced the rating agencies that these new bonds were also AAA bonds.
Then they created a new kind of bonds based solely on the cash flow from the BBB (but rated AAA) bonds, and convinced the ratings agencies to rate them AAA also. They were even given a new name, Sovereign Bonds, even though there was absolutely no real assets backing them.
No wonder poor Hank had such a problem. Wall Street banks, one of which he was just CEO, had turned all of Wall Street's innovations into AAA bonds, the garbage and the gold were indistinguishable. How could anyone know?
Apparently, none of this was illegal. Congress seems to believe that it should all remain legal in the future.
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