On the housing bubble: normally, sub-prime loans are heavily regulated. When a certain lender reports a certain amount of loans are subprime and lists the people who applied for them, if the numbers don’t add up, the regulators will step in and see that the number of good mortgages (ones that are fairly certain to be paid off) is high relative to loans that (per actuarial tables and other research) are much riskier. There’s no way to tell for certain if a loan is going to go bad, but overall certain patterns can be discerned and this ratio of less-risk to risk is kept at an optimum level. This did not happen. There was a sub-prime free-for-all and the regulators (specifically Bush era appointees at the top, like oh… I dunno… The Secretary of the Treasury) didn’t step in. Why should they? They don’t believe in regulation.
On securitization: Again, it’s about ratio’s. As mortgages are bundled together and sold up the food chain, some ratio of good mortgages to bad mortgages (an inexact science)is assumed to favor the good mortgages. This appears not to have happened quite simply because there were no regulations regarding ‘swaps’ (the act of bundling mortgages and adding some default insurance into a form of derivative). That’s thanks to Phil Gramm. The swaps are wholly unregulated. There isn’t even a central marketplace (like an exchange) so there’s no central place to pulbish or analyze prices: they are, in word and deed, made up as they go along.
It gets better (worse?) when you realize that the math behind the risk assessment is slightly off. Basically, they assumed that a loan fails independently of other loans and so can tranch them based on risk per loan. This is probably true in a non-bubble environment, (but I’m not entirely convinced…) But, as has been demonstrated, these events and motivations are not independent and in fact are quite interdependent. In the instance of ARMs, interest rate changes, which are a marker of default, can occur more or less simultaneously (or in a slowly building wave) leading to simultaneous defaults. So, with an ABS where the individual (per loan) risk of default might be acceptable, defaults suddenly occur across-the-board.
This too, is to be expected in an unregulated market. Part of the regulation is simply to see that the math is done correctly.
On leverage More ratios! Prior to the Bush administration investment banks (like Lehman) were limited (by regulators) to a 12:1 ratio of debt, meaning for every dollar they had in capital on hand, they could borrow (or hold) no more than 12 dollars (debt). Anybody who was over this limit was getting closer scrutiny from the regulators. In 2004 the SEC granted 5 companies an exception, Goldman, Merrill Lynch, Lehman, Bear Stearns and Morgan Stanly, to carry upwards of 40:1 ratio. Fannie and Freddie were running over 60:1. But because the swap derivatives hid a lot of bad debt these ratios were almost certainly wrong, and not wrong in a way that would make things better. It is estimated that Fannie and Freddie were running closer to 200:1 ratios..
As foreclosures came in, these companies realized that they owed much much more than they had on hand, and could not determine when the foreclosures would slow or stop. They needed to re-capitalize quick or die. Credit dried up and so did their hopesof recapitalizing.
And that’s the problem today. There is plenty of bad debt out there… we just don’t know where it is… nor how much. So lenders (the putative adults in this scenario) aren’t able to decide whom it is that is credit worthy.
In essence, the Paulson plan is just ‘after the fact’ bookkeeping: they’re offering to buy (up to 700 B) of dodgy securities so they can sort out what’s good and what’s bad, put the good back into the market (hopefully at a profit, or less of aloss…) and deal with the bad ‘by another way…’
On Fannie and FreddieIt’s worth noting, I think that Freddie and Fannie were supposed to guarantee loans to the secondary market (by definition, subprime), if they were bad. They were, as it were, where the buck was supposed to stop. The thinking, such as it was, went along the lines that the vast majority of loans were to be considered good ans so risk would be spread through the securitization of credit and, if anybody had to be hurt by the odd bad loan, it was to be Fannie, then later Freddie. I don’t particularly think this is a good idea, but there it is… it works out OK, as long as the underlying premise, that the amount of bad debt is miniscule compared to the amount of good debt, holds.
But the point, and I don’t think it could possibly be clearer, is that regulators failed at nearly every stage. If the subprime market had been better regulated then no problem. If swaps were regulated and prices publicly available, then no problem. If leverage (debt ratios) had been regulated, then no problem.
At EVERY stage the regulators fell down on the job.
