Poor Credit & The Making of False Gold

I’ve been re-reading The Big Short by Michael Lewis, and one part stood out to me: the alchemy banks used to turn poor credit scores—subprime borrowers—into “gold.” Not gold in the literal sense, but financial instruments sold for far more than their inherent worth.

Turning Subprime Borrowers into “Assets”

The process started simply: lenders gave mortgages to borrowers, often with poor credit scores. These mortgages were then sold to financial institutions like banks, which bundled them together into financial products called Collateralized Debt Obligations (CDOs).

At its core, a mortgage is straightforward:

• A lender provides a borrower with a large sum of money to buy real estate.
• The borrower repays the loan in monthly installments, creating predictable cash flow for the lender.

From the lender’s perspective, if the cash flow could be guaranteed, it became a “sure thing”—an asset. But here’s where things got inventive.

The Art of Bundling and Tranching

Banks bundled thousands of mortgages into CDOs and broke them down into “tranches,” or slices. Each tranche represented varying levels of risk and return:

• Senior tranches: Highest-rated, lowest-risk, with priority claims on cash flows.
• Equity tranches: Lowest-rated, highest-risk, and thus hardest to sell.

But what if you could transform the riskiest, least appealing tranches into something more valuable?

The Trick: Repackaging Risk

Here’s the sleight of hand:

1. Banks took the riskiest, lowest-rated tranches (the scraps of multiple CDOs) and bundled them together into new CDOs, often called CDO-squared.
2. Somehow, this repackaging often resulted in higher credit ratings for the new product. Why? Ratings agencies relied on flawed models that underestimated the correlation between defaults in these repackaged assets.
3. The new CDOs could then be sold at a premium—turning risky assets into “gold.”

The Synthetic CDO and the CDS Casino

Banks didn’t stop there. Enter Credit Default Swaps (CDSs): a form of insurance for CDOs. By selling CDSs, banks collected premiums, creating another cash flow. But here’s where it got wild:

• They used these premiums to create synthetic CDOs, financial products tied to the performance of existing CDOs without owning the underlying mortgages.
• And so they would create CDOs, and sell CDSs to insure it. Take the premiums from the CDS and create additional synthetic CDOs.
• Essentially, they built a house of cards—derivatives of derivatives—multiplying the risk while pocketing fees at every layer.

The Collapse

This lucrative cycle of bundling, insuring, and reselling went unchecked until the inevitable happened: borrowers began defaulting en masse*. The cash flows that supported the entire system dried up, exposing the true risk buried beneath layers of financial engineering. The “gold” turned back into lead, and the global financial system crumbled under its weight.

*It had to happen because our economy runs on cycles: booms followed by busts. At some point, we would enter a recession and thus the most vulnerable would no longer be able to make mortgage payments.

Key Takeaway: The ’08 financial crisis wasn’t just a story of bad loans—it was a cautionary tale about human greed and the dangers of overengineering financial systems. Banks turned the riskiest borrowers into assets by repackaging risk, a process that worked brilliantly—until it didn’t.