So I threw my vote to aviod the best of two evils . . .

The problem with the mortgage crisis was one of transparency and incentives. Essentially, the people who were making the loans and had contact with the borrowers had no incentive (in fact they had negative incentives in some cases) to package loans that were likely to be repaid. This is because the banks and mortgage brokers that made the loans IMMEDIATELY sold them.

Essentially, you can make riskier loans and still profit, as long as the person holding the loan fully understands the risk and has factored that in to their calculations. What happened in the case of the mortgage crisis was that banks/mortgage brokers made loans, then immediately sold them to wall street firms who packaged them into mortgage backed securities (MBSs).

These MBS's consisted of THOUSANDS of loans that were put into one financial unit. This one financial unit was then split into thousands of pieces and sold. The final owners (foreign governments, pension funds, etc) didn't own individual loans on an individual property, but rather a fraction of thousands of loans on thousands of properties. This helped obscure just how risky the loans were, because people didn't know exactly what properties their loans were on. To mitigate this risk, the buyers relied SOLELY on the ratings given by the ratings agencies.

However, once Wall Street firms realized that the ratings agencies would give them high ratings REGARDLESS of how crappy the loans were, they encouraged the banks/mortgage brokers to make as many mortgages they could. The banks/mortgage brokers in turn begin giving loans to people who had ZERO chance of paying it back. Why? Because the banks/mortgage brokers got paid by commission on every mortgage made, NOT every good mortgage made.

Let me offer 2 examples. Lets say you have a person with poor credit, but has a steady job making $30K per year, and is paying $750 in rent per month. She has been late on credit card payments before, but she has NEVER been evicted from her home and her income can easily support her rent. In fact, her credit history shows that when times are tough, her rent is the one thing she always pays, even if she misses a payment on her credit card.

A person like this is a risk to write a mortgage for, but the risk is manageable. She will have to pay a higher interest rate, but as long as her monthly payments are fixed at $750-$850 per year, it is still VERY likely that she will pay her mortgage. You could probably lend her money on a $100K house and have a good chance of it getting paid off.

Folks like her WILL default at a higher rate than traditional borrowers with better credit, but you factor that in by charging a higher interest rate. With enough loans made to people like her, the defaults will be offset by the hire return via higher interest rates paid by the majority who do not default.

So far, so good, right? Now lets talk about another person. This is actually a REAL example of someone. This is a immigrent factory worker who makes $45,000. He got a loan for over $584K for a house. The mortgage payments alone would be $3,000+. How does a guy making just over $3600 per month before taxes pay a $3,000+ per month mortgage? The answer is simple, he doesn't. There is no interest rate, no financing terms, that can be structured to make this a profitable mortgage.

It would seem obvious that one loan (while risky) has a MUCH MUCH higher chance of being paid off than the other. Yet, to a bank/mortgage broker, what does he care if the mortgage is paid, since he will be IMMEDIATELY selling the mortgage before the first mortgage payment is due. In fact, the bank/broker will earn MORE money if he makes the second loan than the first, since he earns his commission based on a percentage of how big the mortgage is.

The problem was that by packaging the loans in the way they were, the TRUE risk was hidden from the final owners of the mortgages. Once the true risk of something is so obscured, opportunities for value collapse are extremely high if and when that true risk is finally uncovered. In this case, not only was the risk obscured, it was distorted via the unwarrented high ratings given to it by the ratings agencies (Moody's, Standard & Poors, etc).

Think about it like this. Imagine there is a bakery that only sells fresh bread rolls. One day they decide to sell day-old bread rolls in bags. Yes, the bread is day-old rather than fresh. Yes, there may even be the occasional stale bread roll in the bag. But since you know that you are buying day-old bread and the occasional stale roll is a possibility, you factor that in and buy the bags of bread rolls at a discount compared to what you would pay for the same quantity of fresh bread rolls.

Now, lets say that the Bakery owner realizes that since he is selling his day-old bread rolls in brown paper bags, you can't actually see how old the bread is until you open it up at home (after you bought it). So he starts throwing in more stale rolls, and even molded rolls that are not edible. He even puts stickers on the brown paper bag that say "Fresh" and "Delicious". You can only go by the labels on the bag, since you can't open the bag without paying for it. You don't find out until you get home that half of the bread is molded AND that the mold has rubbed off on the bread that wasn't originally molded. You may never shop at that bakery again, but he still has your money, and you don't have any edible bread for your family tonight.

 

I agree that banks should hold loans and not sell them on the secondary market. I also like small regional banks over global banks. However, this causes social inequality that the government tried hard to get rid of. The government created Fannie and Freddie to be the nationwide secondary market for loans. Soon the US had the most liquid mortgage market in the world. Fannie and Freddie set the standards, which Bill Clinton lowered to make it easier for risky borrowers to get mortgages. And the rest is history. If we get rid of Fannie and Freddie, problem solved. We could even mandate that banks hold loans to maturity. This would cause banks to only lend to good credit risk individuals with stable employment and documented income. I have family members who are in the mortgage broker business and they would probably disagree with me but hey its my opinion.

 

This one financial unit was then divided into a large number of items and sold. The final owners didn't own personal financial loans on an personal property, but rather a portion of a large number of financial loans on a large number of qualities.