What really happened

The conventional wisdom, already, is that the credit crisis was caused because government wasn’t regulating enough. But no one has explained exactly how regulation could actually have stopped what happened.
Here is the story:
Some smart Wall Street guys (no irony intended) realized that while an individual home mortgage has a default risk, for whole bunch of mortgages together the risk is tiny. So they created new kinds of financial investments by bundling lots of mortgages together, with the homeowner payments then flowing to investors.
So far so good. Then banks began to realize they could make more money by selling their mortgages to these bundlers than by servicing them the old fashioned way. And then they realized that repayment of the loans was no longer their concern. They could make money simply by writing mortgages – any mortgages.
Still the risk, even to the bundlers, didn’t seem too great, because after all, if a mortgage defaults, the lender gets to foreclose and sell the home. With rising home prices, you couldn’t lose.
But then home prices fell; and it turned out you could lose a lot. The mortgage-based securities, which had seemed such a good thing, now became toxic and unsaleable. So all the financial institutions owning these securities were in the soup.
Where, in all this, should government have, or could it have, blown a regulatory whistle? Should it have stopped banks from freely giving mortgages? Was the government supposed to second-guess those bank decisions? Or should it have stopped banks from selling the mortgages on, to the bundlers? On what basis? Or should government have stopped financial institutions from investing in mortgage-backed securities? Aren’t they grown-ups, who ought to have understood the risks they were taking? Should government be looking over those shoulders too?
This was a case of smart people spotting an opportunity to make money by doing something new. And, usually, throughout history, that’s exactly how we progress and grow in prosperity. In this case, the innovation seemed good for the banks – they were making money – good for the creators of the mortgage-backed securities – they were making money – good for their investors – they were earning a reasonable return with what seemed to be reasonably low risk. And it was also good for all the ordinary little people who got mortgages, and homes, that otherwise they would not have been able to afford.
The big irony here is the talk about “predatory lending.” I always used to hear how rotten it was that banks wouldn’t give mortgages to disadvantaged people. Remember all the controversy about “red lining”? Well, here the banks abandoned all that stinginess and started giving out loans to anyone who walked in the door.
The perverse incentive for banks to do that was the unforeseen wrinkle in the seemingly good thing of mortgage-backed securities. But even that would still have worked out okay if home prices had continued their historic rise. So here we see the law of unintended consequences.
But let’s take a deep breath and remember that the whole basic concept of a free market – in which people are at liberty to do with their money what seems best to them, to take what they deem reasonable risks, and to try to capitalize upon opportunities – is no bad thing. If there is one basic truism about financial markets, it’s that you have to take risks to get rewards. It’s true of life more generally. Trying to prevent risk means societal stagnation.
The free market system, propelled by people willing to take risks, has, over the past several decades, resulted in fantastic betterment for society and its citizens, with unprecedented worldwide economic growth and prosperity, and dramatic reductions in poverty and improvements in quality of life for hundreds of millions.
This time, the market laid an egg. But let’s not therefore kill the goose that lays golden eggs.

3 Responses to “What really happened”

  1. Lee Says:

    Capitalism is the worst form of economic system there is … excepting all the others that have been tried from time to time.

    If we are to believe the spin, today’s society has institutions that are too big to fail. Much as we have regulations about monopolies it may be prudent to install some regulations about these institutions. At the very least, if we’re going to bail them out, like we do with the banks, then we should be charging them for the insurance, like we do with the banks.

    The low ball bailout figure of $700B represents about $175K for each of the 4M mortgages in distress. If we’re going to give away $700B, perhaps we should give it to the homeowners. Wouldn’t that make a big dent in fixing the economic crisis /and/ the foreclosure crisis? Unfortunately, I fear that giving money to poor deadbeats is much less politically palatable than giving away money to rich deadbeats.

  2. Bruce Says:

    I stated as early as 2001 that the housing prices were inflated and likely to fall at the next economic downturn. Turns out I am a genius.

    The guys making the mortgages KNEW that they were engaged in a pyramid scheme, as did the realtors, but since both are paid by commission and both were given permission by their bosses to proceed, away they went.

    Even the home owners KNEW that this sudden good luck wouldn’t last forever, but because some of the borrowed 125% (?), why worry?

    The government should not allow mortgages for more than 80%, as this covers everybody’s ass in case of an economic downturn. Also, it should not allow interest-only mortgages, even if it is only for 3 years or less.

    These 2 regulations would have prevented this whole mess. Any economist could have forseen the result, except the Chairman of the Fed – GO FIGURE!

  3. Bruce Says:

    interest-only mortgages = interest-only mortgage payments

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