Death by mortgage
How the rise of real estate led to the fall of Lehman.
NEW YORK (Fortune) -- "It takes two to make an accident.... I hate careless people."
-- Jordan Baker, the shady golf pro in "The Great Gatsby"
"Throw in the towel because I'm makin' 'em sweat
Or put your house on the line and I can cover the bet."
-- Ludacris, "Put Your Money Where Your Mouth Is."
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The road to the Fall of the House of Lehman runs right by the soon-to-be lost home of John and Susan, fictional names of two very real people I know, who until recently lived in splendor in a gilded inland enclave of Central Inland California. These are two truly fine people.
The husband, in his mid-forties, worked for most of his life at two businesses: He originated large but subprime mortgages for people who wanted huge homes but did not have a lot of income, at least not verifiable income; his other business was building large spec homes at fancy prices.
Susan's job, meanwhile, was gently and lovingly urging her husband to make more money so she could be truly rich, not just almost rich. He took the cues and hired more employees and borrowed every dime he could, including multiple mortgages on their residence, to build more homes and hire more mortgage sales people.
For many years, it worked well, and John and Susan had a lush life -- until the strategy fell off a cliff. (Very much like the great Hemingway story about the man who had been rich and became poor in the Great Depression. "How did you get to be broke?" asked Hemingway. "Slowly," said the friend, "then all at once.")
Home prices reached unsustainable levels. People stopped buying. The large entities to which John had been selling his mortgages stopped buying them except at prices that made the interest rates unaffordable. Both businesses collapsed.
But the employees still had to be paid, at least for a while. The interest on the loans definitely had to be paid. The couple became dead broke, sad, got divorced, and now await foreclosure on everything they own in the way of real estate.
If you imagine an entire nation, or a large class of a nation, living that carelessly, you have an idea of the size of the accident that was about to happen and did happen. If you imagine a Wall Street and many Wall Street institutions that were just as careless, that were betting their lives that the boom would go on forever, you have an idea of what happened in 2008 and is still playing out.
Wall Street bought the loans that John and many others originated, packaged them, tried to sell them fast, but some of it simply could not be sold before the house of cards collapsed.
More painful, some Wall Street institutions, especially Lehman, did what Ludacris sang about: They covered the bets on real estate by selling credit default swaps, essentially insurance on the bonds into which Wall Street had packaged the loans originated by small players like John and big huge players like Bank of America (BAC, Fortune 500) and Washington Mutual and Wachovia and Wells Fargo (WFC, Fortune 500).
When the markets and the speculators got an idea of the tsunami of foreclosures and delinquencies that were coming ashore, they sold these mortgage bonds like Sherman burning Atlanta. The insurers were left in an impossible position. They had never imagined a collapse of this magnitude and lacked collateral to cover their insurance bets. Some were broke.
As the traders got wind of this "problem," they simply killed the stock prices of the CDS-offerers, refused to extend credit to the houses in trouble, especially to Lehman, which was never really well-liked on the Street anyway.
In a maneuver out of the Devil's playbook on "How to Create a New Great Depression," Messrs. Bernanke, Paulson, and Geithner refused to rescue Lehman. (They easily could have. Merely for Mr. Bernanke to have said he was going to rescue Lehman would have done the trick.)
The problem became a crisis and the nation fell into a Great Recession. John and Susan cry a lot and wonder what happened. They now realize they should have been a little less careless. It's too late.