Jamie Pirrello Everyone's pointing fingers. Is Wall Street to blame? Are home builders to blame? Are Freddie Mac and Fannie Mae to blame? Or is Washington to blame for the $800 billion rescue and bailout plan recently passed and signed into law?

The fact is that innovation, supply and demand, and faulty financial modeling assumptions are the real culprits.

Innovation in financial markets created demand for mortgage investments. The significant demand of investors resulted in massive credit liquidity. In response to investor demand and liquidity, rapid and radical innovation ensued. Complex financial modeling assumptions allowed lenders to lower underwriting standards to meet burgeoning investor demand. When these assumptions proved wrong, a painful unwinding of the credit markets was necessary.

In the past, savers deposited cash into banks and savings and loans institutions, which used these funds to make mortgage loans. Lenders earned fees on the loans, plus a small spread on the difference between the interest rate paid to depositors and the one they charged borrowers. Mortgage liquidity was limited to the amount of funds deposited.

Then came innovation. Its first wave was the bundling of like mortgages to be sold as a bond collateralized by the underlying mortgages. These bonds are known as mortgage-backed securities (MBSs), collateralized mortgage-backed securities (CMBSs), or collateralized debt obligations (CDOs).

This increased mortgage market liquidity. Lenders could use their deposit base to make a loan, sell the loan into a MBS pool, and replenish their lending base so they could extend other loans. Investor demand for MBS investments expanded liquidity.

But some investors wouldn't buy MBS pools. Their risk tolerance was such that certain pools had either too little risk (i.e., too little return) or too high a return (i.e., too much risk). Vanilla MBS pools stood outside some investors' investing profile.

The response was more innovation. To broaden their investor base, MBS pools were “sliced and diced” into tranches, with varying risk and return profiles. Now, an investor who desired higher returns could invest in higher risk MBS pools, and an investor seeking lower risk could invest in a lower return MBS pool.

Rather than an entire mortgage supporting an MBS pool, a segment of a mortgage—say the top 5 percent, the riskiest part—was bundled together with similar segments from like loans, and these tranches supported an MBS pool. In other cases, the bottom—or safest—portions of mortgages were bundled and used to support another MBS.

Then came the advent of credit derivative swap agreements acting as insurance for investors. If an MBS defaulted, a third party would take all or some of the credit risk. Investors were willing to purchase credit swaps to minimize the downside risk. Credit swap agreements played a major role in the downfall of Bear Stearns, Lehman Brothers, and AIG, as they were large holders of these agreements.