The dishonest brokers didn’t care who they approved for a mortgage because they were paid a fee for delivering the mortgage, not for having the mortgage actually work. The dishonest banks didn’t care about who they were approving, because they were planning to sell the mortgage before the first payment was even due. The investment banks that bought the mortgages didn’t care because they were pushing the risk onto MBS purchasers before the borrowers had a chance to default (even if they never made a single payment).
The Federal reserve should have been monitoring all this and should have noticed what was going on. But Alan Greenspan was too much of an Ayn Rand disciple to even consider regulating a market. So the banks went unregulated and free to make a mess with bad mortgages.
The other opportunity for the government to regulate the mortgage industry came from Fannie Mae and Freddie Mac. As the largest purchasers of mortgages, they got to set the standards that banks wanted to meet. The conforming limit represents the largest mortgages that they were willing to buy. But corruption and a desire for increased profits (to increase executive bonuses) led to lower and lower standards at the agencies. Whenever congress started asking questions, they provided the distraction of “look at how many low-income families can suddenly afford housing!”
The free-market self-regulation should have been low ratings on the bonds. How anyone could analyze a bond full of loans to people who provided no proof that they could pay them back and give it the highest credit rating available is beyond understanding. But that is exactly what the credit rating agencies did. With no pushback from the ratings, the investment banks saw no reason to demand higher standards from the banks. People trusted the ratings agencies to do their jobs properly, so they bought the bonds without asking any further questions.
So if that is how the free market failed to work, how can it be made to work better?
The first thing that should be done is to no longer allow anyone to pass on the risk completely. At each step of the way, anyone involved in approving or selling a mortgage should be required to hold onto some of the risk. The mortgage brokers should be required to put in some money to keep them honest. The banks should be required to hold a portion of the mortgage junior to what they sell (meaning that they take the first loss). The investment banks should be required to take a junior holding in their securities.
And then there are the credit rating agencies. Clearly something is wrong with them. They completely failed in the entire mortgage bubble. The only way to keep them honest would seem to be forcing them to take on some of the loss whenever they overrate a security. At the same point, even some AAA securities are expected to default. Perhaps their fee structure could be set up so that they will only make money if they accurately forecast the probability of a bond defaulting. Perhaps they should be fined for every bond that fails, with the fine being based on a formula that includes a term that shows their expected probability of default. So for example, if they estimate that a bond has a 4% chance of defaulting, then they would have to pay a fine of 20 times their fee if it does default. If they are correct or overly conservative, then they make money. If they underestimate the default risk by very much, then they will lose money.
Fannie Mae and Freddie Mac should have standards that are based on reasonable affordability guidelines. They should calculate an affordable payment based on the borrowers documented income. They should reject no-doc loans under all circumstances. Then they should refuse to buy any loan which has a maximum feasible payment (so at the highest possible adjusted interest rate for ARMs) below the affordable guideline. They should also require a downpayment paid with funds from the borrower, since that has been shown to reduce the risk of defaulting.
Deregulation let the housing bubble get out of hand. We need to reregulate the mortgage market to ensure that it doesn’t happen again.