The “subprime mortgage” mania began in 2004 when lenders started giving out mortgages to almost anyone — with little or no proof of income — because of profits that could be made off fees, high interest rates and reselling the mortgages. To sell subprime loans, lenders gave low rates for the first two years.

After this the mortgage rate would shoot up, sometimes doubling or even tripling monthly payments.

Caught between stagnant wages and rapidly increasing house values, Americans turned their homes into cash machines this decade and withdrew trillions of dollars in equity. By last year, many subprime loans were resetting at higher rates and homeowners started to default. This cooled off the housing market fast. Jobs were lost in real estate, construction and home lending, and retail spending slowed, slowing the economy.

How does this link to the financial sector?

Say you’re Bank of America. You have 1,000 mortgages lying around, so you “bundle” them and create “mortgage backed securities” (MBS) to sell to banks, hedge funds and foreign investors. You get your cash back, and a steady stream of fees for managing the mortgages. To sell MBSs, you go to a ratings agency like Moody’s Investor’s Service or Standard & Poor’s. You slice up the bundle like cuts of beef. The choicest MBSs get Aaa ratings, meaning they will almost certainly be paid back. The ratings go down — Aa, A, Baa, down to Ccc and then unrated — according to the likelihood they will be paid back.

As lenders were writing trillions of dollars in mortgages to sell, not to hold, they didn’t have an interest in seeing the loan repaid.

Then, lenders took risky mortgage backed securities (rated Bbb, for instance) and repackaged them as highly attractive Aaa financial products. Some of these are called “collateralized debt obligations” or CDO. Ratings firms generated huge profits from giving these dodgy products the seal of approval. Moody’s earned nearly $850 million from structured finance products in 2006 alone.

The final player is “monoline” insurance companies, which insure more than $1 trillion in municipal bonds. If a city wants to build new schools or roads or expand mass transit it sells bonds. To lower costs, a city buys insurance from monoline insurers, such as MBIA or Ambac. This makes the bond more desirable to the buyer because the insurer will pay out if the city defaults.

Just as lenders pushed risky subprime mortgages, monoline insurers started insuring mortgage backed securities.

An example shows how this works. Suppose your company is Goldman Sachs. GM wants to borrow $100 million. You give it a loan at 5 percent interest, which means they pay $5 million a year in interest. To be sure your loan is safe you buy insurance from MBIA. Deciding GM is a good risk, MBIA sells you the policy at 1 percent. So while GM pays you $5 million a year, you pay MBIA $1 million a year to assume the risk. If GM defaults on the loan, MBIA will cover the loss.

These insurance contracts are known as “credit default swaps.” Taking the example above, GM starts bleeding money and can’t service its debt. This causes the value of your loan to decline, but the value of your insurance contract, the credit default swap, rises because it’s more likely it will have to be paid out.

Here’s where things get nutty. An unregulated market, totaling a breathtaking $45 trillion, grew up as banks, hedge funds, brokers and insurers sold these swaps back and forth. It’s pure gambling, where buyers and sellers often do not hold the underlying debt. As hundreds of thousands of homeowners began defaulting on subprime loans, many MBSs started going bad, too. By last year, there was $1.3 trillion in CDOs worldwide and 56 percent of this was made up of mortgage backed securities.

By last year, one small monoline insurer, ACA , had accumulated more than $69 billion in exposure to corporate and mortgage debt but only had $425 million of capital to cover it. Ratings agencies also review insurance firms, and ACA had a single A rating. Then it reported a loss of $1 billion last November from MBSs. A month later, it was downgraded to a junk rating of Ccc.

This made ACA ’s insurance policies worthless, affecting the value of the debt they insured. Fearful this could lead to a market panic as players tried to “unwind” their swaps, banks have been negotiating to rescue the insurer, but already Merrill Lynch, CIBC and Citigroup have written off billions of dollars in losses linked to ACA. Losses this year on swaps could total $250 billion, equal to the expected losses in the subprime market.

The damage is spreading on Wall Street with large job cuts in finance and a credit crunch that’s making it harder for businesses and homeowners to borrow. This creates more problems. As foreclosures multiply and property values decline, many cities and states are facing huge tax shortfalls. On the cusp of recession, they have to borrow more money to fund operations. But as monoline insurers are downgraded, the cost of insuring municipal bonds goes up. In addition to the blow of a recession, Americans will see government services slashed and having to pay more for the services that remain.

Wall Street made staggering profits from the housing and credit bubbles.

Now that they’re taking a beating, the Federal Reserve and U.S. Treasury Department are bailing them out on the public’s dime by pumping tens of billions of dollars into the market and by lowering interest rates, which fuels inflation. Thus, profit is private, but losses are socialized. Such is the free market.

GLOSSARY

Bond—a bond is an instrument of debt issued by corporations and governments. For example, Boeing issues $1 million bonds with a 20-year maturity at 5 percent. This means the buyer purchases the bond for $1 million, gets 5 percent interest per year ($50,000) for 20 years, and at the end gets paid back the principal of $1 million.

Collateralized Debt Obligation—a complex security that can be based on a wide variety of debts such as mortgages, credit card debt, auto loans, etc.

Mortgage Backed Securities—are either commercial or residential mortgages that are bundled to create a bond. The pool of mortgages acts as asset for the MBS and generates cash payments to the buyers in the form of interest and principal from the mortgages.

Subprime mortgages—sometimes labeled “predatory lending,” this means greater than the prime rate, currently 6.5 percent, which is the lowest interest rate banks offer to their best customers.

Illustrations by Frank Reynoso