“Eventually the knockwurst and bratwurst started to make people sick.”

From Bloomberg:

Wall Street Mill Churns Out Bad Wurst: Caroline Baum

A homeowner in Irvine, California, defaults on her mortgage; two Bear Stearns hedge funds implode.

French banking giant BNP Paribas halts withdrawals from three of its investment funds; the world’s central banks have to inject hundreds of billions of dollars into the money markets over a two-day period to keep interbank lending rates from soaring.

Unrelated events? Hardly. What was once touted as a problem with a niche product (subprime loans) in a small sector of the U.S. economy (residential real estate) is somehow strewing its detritus across the globe.

How did it come to this? How is it that home loans to Main Street became a crisis for Wall Street? The answer owes as much to human nature as to the nature and complexity of structured finance.

Our story begins with an extended period of low worldwide interest rates designed to ease the pain of the burst bubble in Internet and technology stock.

Housing is an interest-rate sensitive industry. In the U.S., residential real estate weathered the 2001 recession with flying colors, courtesy of the Federal Reserve, which cut its benchmark rate to a level not seen in almost half a century.

Potential homeowners responded to the incentive of low rates to buy the house of their dreams. Sometimes they bought two: one to live in, one to rent and/or eventually flip for a profit.
…
The ability to meet timely payment of principal and interest wasn’t an issue for homebuyers when prices were appreciating at rates of 10 to 15 percent a year, which was standard from 2002 through early 2006. It clearly wasn’t an issue for lenders either, who helped would-be buyers secure the financing — no money down, no questions asked. The more exotic the mortgage, the juicier the commission.

There were plenty of signs along the way that a bubble was developing. The appearance of Web site condoflip.com, for example, with its pitch of facilitating the purchase and sale of preconstruction condos, epitomized the froth that was building in the housing market.

And why not? The Fed, worried about deflation even in 2003, didn’t start to raise its overnight rate from a low of 1 percent until May 2004, with the economy taking off.

Enter Wall Street, which is essentially in the sausage- making business. It takes meat and meat by-products and processes them into wurst, which it hawks to investors both sophisticated and naive.

In the case of subprime loans, which were packaged into mortgage bonds and sliced and diced into collateralized mortgage obligations, there was just enough real meat for the securities to be certified as kosher (AAA) by the rating companies.
…
Eventually the knockwurst and bratwurst started to make people sick. Upon testing, the sausage was found to contain too little meat and too much by-product. It wasn’t kosher after all.

On further examination, the entire sausage production and distribution chain — from homebuyers to mortgage lenders, from mortgage brokers to securitizers — was found to be operating under unsanitary conditions and pretty much shut down until further notice.

And it wasn’t just the wurst that was declared unfit for human consumption. Anything suspected of containing meat by- products was shunned by investors in favor of food with a federal government guarantee.