Imagine I have £200,000 and I wanted to set myself as a lender to people who can't get credit elsewhere.
A friend of a friend wants to buy a house - at the absolute outside they can afford to spend £180,000.
Another friend of mine is an estate agent has a house on his books that is worth £160,000. He knows a crooked mortgage valuer who is willing to value it at £200,000.
The estate agent convinces my friend to buy the house at £200,000 - I convince the buyer to tell some little fibs about his income to justify my lending him £200,000 over 10 years.
The situation to date therefore is as follows :-
Me : Pockets a nice fee for setting up the loan. I know the borrower is likely to struggle with the repayments and may need to remortgage later - meaning another nice fat fee in the future.
Estate Agent : Shifted a house and received a bigger commission on the inflated price
Valuer : Took a kick-back from the estate agent
Buyer : Owes £200,000 on a house currently worth £160,000. This is not a big deal as long as prices keep rising.
Now things get complex.
The borrower will pay a total of £325,000 over the 10 years of the mortage. To put a value on this loan there's a complex formula involving Net Present Value, Probability of Defaulting on the loan etc. etc. I could care less about this, because I'm a man in a hurry. I sell the loan to TotallyMadeUp Bank for £250,000.
TotallyMadeUpBank then package my loan in with a bunch of others, and sells them on in the form of a bond to ToutaFaitExceptionelle MegaBank and similar large banks at a healthy profit.
Situation now is :-
Me : Made a quick £50k profit. I now have £250k to invest, and go looking for new needy people. As time goes on, I need to work harder and harder to find new takers for my services, contemplating worse and worse credit risks and cutting corners more often than not.
TotallyMadeUp Bank : Made a quick profit, just by slicing and dicing the debt and selling it on. Decides to create a whole Cayman Islands-based subsidiary to deal with this profitable business.
ToutaFaitExceptionelle MegaBank : Holds a bond that looks cheap compared to government and commercial debt. In fact, some of these bonds are rated as "AAA" by the debt rating agencies - as safe as General Electric or the US Government.
Now imagine the housing market tanks and so does the job market. My borrower loses his job, and is unable to pay the mortgage. The house is now valued at £140,000. The borrower has no option but to abandon the house. A number of other mortgagees become ex-home owners at the same time.
Me - I owe TotallyMadeUp Bank a ton of money - I have to sell the abandoned houses in a huge hurry, further depressing the market. I go bust.
TotallyMadeUp Bank - The Cayman Islands subsidiary goes bust as a result of the bankrupcies of smaller lenders like myself.
ToutaFaitExceptionelle MegaBank - The bonds they own are next to worthless. Fortunately they are "too big to fail", so the government (tax-payers) bail them out.
So, let's look at the final position :-
Borrower - homeless, deep in debt, possibly personally bankrupt.
Me - Bankrupt
TotallyMadeUp Bank - Out of pocket
ToutaFaitExceptionelle MegaBank - Some bad publicity, but otherwise unharmed
Taxpayers - Out of Pocket
So -who's to blame and how do we stop it happening again?