Crime and Crisis, Opportunity

So we have supply and we have demand. Isn’t that enough? Not in the financial market, which is one of the most heavily regulated markets of them all. Understanding why it is so regulated will help us see the effects of the regulatory changes and also explain some of the nature of the present crisis. Both deregulation and inappropriate regulation provided the opportunity. Both excessive belief in the perfections of the economic model - and disbelief in the reality of economic laws opened the door to excessive risk taking.
The financial sector deals in promises. Unlike the auto industry, that sells you a very concrete object that provides well-understood services (although there is the implicit promise of the car continuing to work past the test drive), the financial industry deals entirely in a promise to pay back in the future, sometimes at an indeterminate date, oftentimes with an uncertain return, nearly always through mechanisms whose implications nearly no one understands fully.
Because the business of the financial sector is to use other people’s money - lots of other people’s money, people who may not even have an incentive to know what the financier is up to - the consensus has been developed through long and hard experience that standards must be developed and enforced to make the indeterminacy more determinate, the uncertainty less foggy, and the mechanisms less mysterious. And also to make sure that the incentives of the provider of financial services are aligned with the provision of the services they purport to offer.
Beginning in the late 1960s, but accelerating in the 1990s, there were a number of very important regulatory changes in the financial system of the United States. The slow erosion and final repeal of the Glass-Steagall act is most frequently cited, but the changes to the incentives and structure of Fanny Mae and Freddie Mac, so deeply involved in the crisis, and also the application of the Community Reinvestment Act, which intended to make sure people who couldn’t afford a loan got one, also played a major role. Purposeful regulatory forbearance and unenforcement as well as active encouragement and requirement - due to free-market ideology and to a desire to use the financial sector as a tool against poverty - led banks a) to take too many risks by lending to people who couldn’t afford the loan and b) to find ever-more-creative ways to pass off the risk to someone else.
And indeed this worked beautifully. Most buyers are overwhelmed by the immensity of a multi-decade commitment on an asset worth many times their income, especially when already in terror at their financial situation and only too willing to hear good news. And good news would be told by financial advice books at airports and infomercials and co-workers and mortgage brokers: here’s the deal of a lifetime - real estate - don’t pass it up!
A most willing victim would let himself be seduced by a mortgage broker, who would then would pocket his fee, and pass on the risk - of which he might have been too aware, since he knew that the loan could not possibly be paid back, not at that loan-to-value ratio, not at that debt-service-to-income ratio, not at the post-teaser rate - to some other institution by selling the loan. The loan would then be securitized, pooled, sliced, diced, repooled, sliced and diced again, until the original mortgage would be spread among a million people with a million incentives - and each piece would be radically different from the next, with different seniority and different proportions. Perhaps more importantly, different levels of financial alchemy would have been performed on the different parts of the mortgage, so that in the end no one had any firm clue how to price the resulting slice of the slice of the slice of the asset.
This is key. No one knows for certain what one of these pieces is worth. In tranquil times, with the economy close to the steady-state and the model near its equilibrium, the computer would spit out a reassuringly profitable number through some arcane mathematical simulation. But real people didn’t have a clue, and the mathematical models did not apply in, say, a situation of double-equilibria such as characterizes a bank run, as Diamond and Dybvig taught us several decades ago.
But if the original mortgage - not the securitized-derivated-swapped asset - was in itself completely unsustainable because the house was too expensive and the only way one could buy it was through a miniscule teaser rate, and if laws required the lender to disclose the timing of the reset, why did borrowers not balk at the terms? Because they were seduced, and they let themselves be seduced. Because they needed to borrow to pay for their kids’ college. The loan amount could continue to grow because house prices could never fall, and indeed they would continue to rise exponentially. By the time the teaser rates were up, borrowers refinanced their subprime loans in droves, postponed the Day of Judgment another couple of years. In the meantime the broker and every middle-man in the process collected fat fees, the ultimate holder of a sliver collected a high risk-adjusted rate of return, and the homeowner continued to occupy his too expensive home.