Toward the end of the decade, Wall Street investment firms began hiring PhDs in mathematics and physics to create incredibly complex algorithms capable of modeling elements of the stock and futures markets. In most cases, the creators of these algorithms knew next to nothing about the financial industry, and the executives who employed them knew (literally) nothing about the mechanisms their firms had begun to rely on for their trading strategy. Destabilization of the Home Mortgage Industry:
In the early 1970s, stock analysts at Salomon Brothers, another Wall Street investment firm, developed a new kind of security based on home mortgages, called mortgage-backed securities. In principle, this allowed the conversion of illiquid (i.e. non- tradable) assets like the debt represented by home mortgages to be converted into a tradable commodity for profit. This new form of commercial transaction evolved into incredible levels of complexity after the widespread incorporation of mathematical algorithm-based trading and powerful computers within the investment banking and securities industry. By the end of the 20th century, billions of dollars were being traded on securities whose value lay in the combined debt owed by millions of individual homeowners. However, at roughly the same time, deregulation of the entire financial services sector fundamentally changed the age-old relationship that had always secured the home mortgage, since its inception. Specifically, prior to deregulation, banks, other lending institutions, and mortgage brokers had a vested interest in ensuring that they avoided extending credit to unqualified borrowers whose income, credit history, and available collateral indicated a low risk of default. Once deregulation allowed banks to sell off their mortgage debt to third parties instead of retaining them (and the risks associated with default) on their books, the incentive...
The immense profitability of mortgage backed securities generated intense momentum to issue as many mortgages as possible, in addition to myriad other forms of consumer debt. Millions of Americans took possession of homes they could not afford, many of whom refinanced every year, taking money out of the closing, by virtue of rapidly increasing home values caused by the mortgage lending spree. The industry became proliferated with "stated income" and no documentation ("no doc") mortgages that were also known as "liar loans" because everyone involved in the initial mortgage transaction fraudulently misrepresented financial information.
Lenders and brokers began offering variable interest rates at far below the prime mortgage rate to entice buyers to satisfy the continual demand on Wall Street for mortgage backed securities. When the first wave of unqualified borrowers began defaulting after their variable rates increased to the prime rate, the entire artificially created housing bubble burst, leaving millions of homeowners unable to pay and obligated for more than their homes were now worth as the collapsing housing bubble reduced the prices that had been inflated by irresponsible lending. Ultimately, the housing market collapse triggered the collapse of the entire economy because so much of the equity of large banks and insurers were dependant on the integrity of home mortgages.
References
Phillips, Kevin. "Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism" New York: Viking (2008).
