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11

THE BUST

CONTENTS

Delinquencies: “The turn of the housing market” ..............................................
Rating downgrades: “Never before”....................................................................
CDOs: “Climbing the wall of subprime worry”..................................................
Legal remedies: “On the basis of the information”..............................................
Losses: “Who owns residential credit risk?” .......................................................

What happens when a bubble bursts? In early , it became obvious that home
prices were falling in regions that had once boomed, that mortgage originators were
floundering, and that more and more families, especially those with subprime and
Alt-A loans, would be unable to make their mortgage payments.
What was not immediately clear was how the housing crisis would affect the fi-
nancial system that had helped inflate the bubble. Were all those mortgage-backed
securities and collateralized debt obligations ticking time bombs on the balance
sheets of the world’s largest financial institutions? “The concerns were just that if
people . . . couldn’t value the assets, then that created . . . questions about the solvency
of the firms,” William C. Dudley, now president of the Federal Reserve Bank of New
York, told the FCIC. 
In theory, securitization, over-the-counter derivatives and the many byways of the
shadow banking system were supposed to distribute risk efficiently among investors.
The theory would prove to be wrong. Much of the risk from mortgage-backed securi-
ties had actually been taken by a small group of systemically important companies
with outsized holdings of, or exposure to, the super-senior and triple-A tranches of
CDOs. These companies would ultimately bear great losses, even though those in-
vestments were supposed to be super-safe.
As  went on, increasing mortgage delinquencies and defaults compelled the
ratings agencies to downgrade first mortgage-backed securities, then CDOs.
Alarmed investors sent prices plummeting. Hedge funds faced with margin calls
from their repo lenders were forced to sell at distressed prices; many would shut
down. Banks wrote down the value of their holdings by tens of billions of dollars.

