Sunday, September 28, 2008

What really happened on Wall Street

There's a toxic meme going around that the Democratic-supported proposals to help encourage home ownership are the reason for the huge financial troubles we're facing.

The Democrats encouraged the creation of creative methods of financing a home purchase, the accusation goes. And, presumably, once those methods existed, Democrats went into major banks and said "and if you don't make thousands and thousands of bad mortgage loans, we're going to kill this puppy!"

Well, no, nothing like that happened. What happened was greed.

There was a time when, if a bank loaned you money for a house, the bank would own that loan until the day it was paid off, so they were super-careful about who they lent money to. If you defaulted, they'd have to go into foreclosure, which was a time consuming and expensive process, and they ended up not getting their money back until they re-sold the house.

But then, people started buying and selling mortgages a lot more often. Suddenly, originating a mortgage wasn't as big a deal. Sure, you had to do some pesky paperwork, but you'd make the loan, then sell the loan, and get the money back, so you could originate another loan. The lender was now, in large part, shielded from the consequences of a bad loan. It was now in the lender's best interest to make as many loans as possible. The loans have to be good, of course, because no one wants to buy a bad loan. But more loans = more profit.

So greed says, let's see if there's a way to get more applications and get rid of some of the initial paperwork. Enter the mortgage broker... a person who makes money connecting lenders and borrowers.

Greed gets to play a double role here. First, the desire to get more loan applications, and cut back on the expense of screening leads to the use of the brokers. Second, the brokers themselves want to get as many commissions as possible, and while many will act ethically and properly, some will cheat, or let the borrower cheat, because who is going to notice? The bank? Probably not; they probably sold the loan. If the person who owns the loan tracks it back to a particular broker, well, every broker will make a mistake once a while, right?

That's the baseline root cause of this. Banks, who were partially immune to the risk of default, wanted to make a lot of loans. And, brokers who were almost entirely immune to the risk of default, wanted to get a lot of loans made.

It's true, this couldn't have happened with an old fashioned set of loans, where anything less than a 20% downpayment is considered extremely risky, and all loans are for fixed terms with fixed payments.

At the same time, there's nothing to say that a "no money down" loan has to be bad either. If a bank looked at the person's circumstances, and could determine that the risk of default was low, such a loan could be good for lender and borrower both.

The biggest problem was not the loan type; it was greed, coupled with a lack of consequences for a bad loan.

There's more, of course... there's the whole set of reasons the bad mortgages spread so that they infected such huge portions of the economy, but that's a story for another day.

The root cause had little to do with the specific loan types; it had everything to do with what happens when you let people make lots of money while protecting them from the consequences of bad decisions, and let them act without any oversight or standards.

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