Two sensible posts here and here.
I see a few elements as essential. Millions of Americans were overoptimistic about future home prices. Financial institutions developed new instruments to securitize mortgages, and particularly subprime mortgages. By bundling many mortgages together, and then cutting them into slices or tranches, they created new securities. Risky tranches were first in line for any losses, providing an ablative layer of high yield junk to protect the senior tranches, which could then be sold as investment grade securities. Because more capital could come from risk averse institutions, more could be sold.
Underwriters and rating agencies were grossly overoptimistic about default rates, so many of the tranches originally rated as very safe AAA securities were in fact vulnerable to significant loss. When this became clear they were no longer appropriate investments for the institutions that held them, banks who depended on short term capital and leverage. Banks wanted to sell their holdings.
Unfortunately, the amount at stake was staggering. A few years ago there was $1.5 trillion in subprime mortgages outstanding. The face value was overoptimistic, but even with high default rates the value if held to maturity was probably at least a trillion dollars. To put things in perspective, if the original loan assumed zero defaults, a 70% default rate with every default losing half of the loan value would produce a markdown to 65% of face value.
A trillion dollars is a lot of money. Private equity invested something less than $700 billion worldwide in 2007, before the current credit crunch. Potential buyers for subprime securities needed to be patient enough to tie their money up for years if necessary, and willing to accept significant risk of loss of principal. Many potential sources of capital would fail at least one of those tests. On these terms, there are a lot more potential sellers than buyers. Buyers could arrange deals with the most desperate sellers, but these represented fire sale prices, as little as 22% of face value. Most potential sellers would rather hold their subprime assets to maturity than sell at the price offered. The market for these assets is essentially frozen.
The Paulson plan offers a way out. Measured by value to maturity, $700 billion probably can’t buy all the subprime assets. The institutions that want to sell will need to accept a discount for their illiquid assets. At the same time, they will get a lot more than the current fire sale price on offer from private investors.
This could work.