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Mortgage brokers are responsible for about 70 percent of subprime loans. Many brokers make prudent loans, but a lot did not. According to Aaron Krowne’s Internet-based Implode-o-Meter, from late 2006 to June 2008, 262 major U.S. mortgage lenders had gone “kaput.”10 The number continues to climb.This is an unprecedented failure rate.

The Alt-A mortgage market includes borrowers that have higher credit scores, but not high enough to qualify as “prime” borrowers. In both the Alt-A and prime markets, borrowers have purchased multiple dwellings with little or no money down. As housing prices drop, these borrowers find they have to sell property at a loss if the debt burden becomes too much for them.

Fraud on borrowers is a problem, but so is fraud on lenders. Borrowers, often in collusion with unscrupulous brokers, supplied phony documentation or engage in identity theft. Lenders have a right to complain about this type of fraud, but their own due diligence standards should certainly be tightened.

Investment banks funneled money to mortgage lenders by purchasing the mortgage loans and storing them in special purpose companies known as warehouses. Once there were enough loans, thousands of loans, in the warehouse, they packaged up the loans into residential mortgage-backed securities (RMBS) and sold them to investors. As long as the banks could keep stuffing the loans into securitization packages and selling them, they did not have to keep the risk themselves. If you are ethically challenged and have reason to know you are building airplanes with defective parts, you will sell the airplanes as quickly as possible. That way, when the parts give out, someone else will fall out of the sky. Unfortunately for investment banks (and mortgage lenders that sold them the loans), they got stuck, and their earnings crashed.

Mortgage lenders were obliged to take back loans that did not meet certain standards. Some of the loans made in 2006 and 2007 were so bad that they began defaulting before an investment bank could get rid of the risk (by selling packaged loans to investors like mutual funds and others). Shaky mortgage lenders could not buy back the bad loans without borrowing money from another investment bank. When things got bad enough, investment banks stopped lending and the shaky mortgage lenders went bankrupt. Many investment banks were stuck with mortgage lenders’ unpaid loans and with a warehouse full of bad subprime loans.

One really can’t say this enough: Warren advises that you shouldn’t lend money to people who cannot pay you back. Investment banks—acting as indirect mortgage lenders, bought up the mortgage loans and supplied money to shaky mortgage lenders.They kept the “party” going.

Before the party ended, mortgage lenders siphoned off fees and dividends. When everything unraveled, many mortgage lenders had no value to their shareholders and could not pay back their loans from investment banks (“old investors”), without the money provided by the “new investors,” to whom investment banks sold the packaged dodgy loans. Perhaps your mutual fund. The only thing that kept the money train moving was the fact that money from “new investors” was used to generate the illusion of high returns for “old investors.” That is a Ponzi scheme. A Ponzi scheme raises money from “new investors” so “old investors” can be paid a return on their money even though the business model is a failure. When Ponzi schemes unravel, even “old investors” lose some of their money, and the “new investors” lose much more. Only “old investors,” who get out very early, escape unscathed.

In late 2006, I saw a prospectus for RMBS that took hundreds of mortgage loans, put them into a portfolio, and sold the risk to investors. The deal seemed targeted for foreign investors and showed a portfolio including first and second lien (piggyback) mortgages. Some were adjustable rate, some not. The portfolio included negative amortizing product and interest-only product.The loans were purchased from various