The following was inspired by an anonymous Internet posting.

Loan origination

Applicant: I'd like to buy a house but I don't have a down payment.

Mortgage broker: No problem. I have access to 500 banks. I can get you a loan.

Applicant: What size loan?

Mortgage broker: You're purchasing a house for $450,000. Don't worry that it was listed last week for $400,000. The seller has agreed to make a $50,000 down payment.

Applicant: Excellent.

Monthly payment

Mortgage broker: Here's your monthly payment.

Applicant: Wow. I'm not sure I can handle that.

Mortgage broker: Here's the amount of your payment if we charge interest only for three years at a 3% rate. Then, the rate will adjust to 7% and you can reduce the principal.

Applicant: Perfect. I can handle that.

Ability to pay

Mortgage broker: I need to know your annual earnings from your job.

Applicant: If I get a promotion, it will be $45,000.

Mortgage broker: Are you sure it won't be more? What's the most it could be?

Applicant: Well, if I get two promotions, it could be $90,000.

Mortgage broker: $90,000 it is. You look like an honest person.

Applicant: I am.

Mortgage broker: Good news. We got a loan for $400,000 with interest-only payments at 3% for three years and an attractive 8% rate for 27 more years.

Applicant: What happens if I can't make the payments at the end of three years?

Mortgage broker: No problem. You see home prices. Sell the house at a profit and buy another house.

Applicant: Only in America!

At the retail bank

Lending officer: We've accumulated some mortgage loans, but I'm concerned about them. They look risky if housing prices fall.

Bank manager: Good news. We sell them to an investment banking firm.

Lending officer: How much of the portfolio should we sell?

Bank manager: All of it. The real profit is in the fees we charge. By selling the loans, it frees our capital and deposits so we can make more profitable loans.

Lending officer: Sounds like a good strategy to me.

Investment bank assesses risk

Vp: As you directed, I purchased all these mortgage loans from retail banks. The collection contains highly risky mortgages.

Partner: Don't worry. We have a strategy. We're creating a financial security called a collateralized debt offering. We'll sell the packaged mortgages to investors in the form of this security.

Vp: Is it risky?

Partner: Not really. Only a small portion of mortgages are likely to default at any one time. And rising house prices will create minimal losses when we sell the houses to pay off the security holders.

Investment bank reduces risk

Vp: Will we hold any of the mortgages ourselves?

Partner: Yes. We'll divide the offering into three tranches:

nConservative: Highly safe.

nModerate: A good return for the risk incurred.

nAggressive: A high return for the higher risk incurred.

Vp: What if housing prices don't continue to go up?

Partner: That's the beauty of it. We'll only hold the conservative tranche.

Rating strategy

Vp: Who'll buy the moderate and aggressive tranches?

Partner: Not widows and orphans. We're honest and ethical businesspeople. We'll sell them to our sophisticated institutional clients and our preferred wealthy individual investors.

Vp: Will the security offering be evaluated by the rating agencies?

Partner: Why not? We have a AA rating ourselves. We'll guarantee payment on the conservative tranche, so our rating will apply.

Insurance reduces risk

Vp: What about the risk to us if we guarantee the payment to investors in the conservative tranche?

Partner: We'll buy insurance to protect us against an unexpected loss.

Vp: What about the moderate and aggressive tranches?

Partner: No guarantee by us or insurance, but remember that these securities are very complex to evaluate. We should get BBB or something like that, which isn't bad for the high return offered by the tranche.

No disclosure

Vp: We'll hold some mortgages and guarantee others. Will the auditors require us to disclose the risks?

Partner: Not really. Auditors don't require the disclosure of certain categories of risk on financial statements. It is legal to:

nSet up an offshore shell company.

nTransfer risky assets to the shell company.

nExclude the assets from the balance sheet of the parent company.

Regulator role

Vp: What about the regulators in Washington? Fannie Mae? Freddie Mac? The SEC?

Partner: Fannie Mae and Freddie Mac exist to help Americans own their own homes. They will be very supportive.

Vp: And the SEC?

Partner: The SEC knows these are complex securities but doesn't understand the risk in them. With our guarantees and insurance, high ratings and sophisticated buyers, the SEC will not be a problem.

Congressional role

Vp: What about Congress?

Partner: With all the money we pay to congressmen, I don't expect any problems at all.

Aftermath

Applicant: What happened?

Mortgage banker: What happened?

Local banker: What happened?

Investment banker: What happened?

Auditor: What happened?

Regulator: What happened?

Congressman: What happened?

Institutional investors: What happened?

Individual investors: What happened?

Former homeowners: What happened?

Answers: Countrywide, Merrill Lynch, Bear Stearns, Washington Mutual, Lehman Bros., Fannie Mae, Freddie Mac, AIG.

The end. Or just the beginning?