CNBC Special Report: House of Cards

In 2004, in the midst of the housing boom, President George Bush had a chance to do a little bragging in his State of the Union Address.

“This economy is strong and growing stronger," he said, to applause in the House chamber. "New home construction (is at) the highest in almost 20 years. Homeownership rates (are at) the highest ever.”

Just one month later, then-Federal Reserve Chairman Alan Greenspan encouraged the mortgage industry to come up with new kinds of loans — so even more people could buy homes.

“American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage,” Greenspan recommended in a speech to the Credit Union National Association.

It was music to the ears of Wall Street bankers like Michael Francis. His business was to pool mortgages and sell them to investors who would then get the monthly payments those mortgages produced. The more mortgages lenders provided to homebuyers, the more “product” Francis would have to sell. (Francis asked CNBC not to disclose his employer's name.)

But Francis said there was a downside to Chairman Greenspan’s encouragement to mortgage lenders.

“The unfortunate thing that grew out of that was a program that was a very inappropriate loan program for a lot of people that took it," he said. " And it became extremely popular.”

The program had a name only a banker could love: “the pay option negative amortization adjustable rate mortgage.” It was designed to help first-time homebuyers who couldn’t actually afford the cost of the loan. Those homebuyers would have the option to pay only part of the interest they owed each month. The unpaid interest was added to the total amount of the mortgage. As a result, the mortgage balance increased; instead of the mortgage being paid down, it was getting bigger.

Even this so-called “negative amortization” loan seemed to be acceptable to investors — as long as home prices continued to go up. The mantra on Wall Street was that home prices nationwide had not gone down in a single year since the great depression. That’s what kept Michael Francis going, even if he was starting to have doubts.

“It didn’t feel right,” he said. “Not every loan anyway. We were allowing people to leverage their homes a little bit too much.”

It may have given Michael Francis pause, but it didn’t matter to most other Wall Street bankers as long as they could pool together thousands of these mortgages, carve them up and profitably sell them as securities.

The key to getting investors to buy those mortgage-backed securities was to get them stamped with a seal of approval. Big institutions like police retirement funds and universities would only invest if the investment rating agencies — Moody’s, Standard & Poor’s, and Fitch — gave the securities an “investment grade” rating. “Investment grade” can range from the safest triple A-rated investments to the lower triple B-rated investments. Because a triple A security is safer, it pays less than a riskier triple B.

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