OK, some perspective is needed here.

There are some valid points made in the long article, and there are some significant omissions.

First off, if the underlying mortgages were performing, there would be no problem. None of this other stuff would matter if the mortgages were cash flowing the way they are supposed to. As a corollary to that, once the bad mortgages were made, some sort of crash became inevitable. All the packaging and credit swaps and all that stuff had a bigger impact on precisely who got taken down and when, but they didn't cause the crisis; it was inevitable by the time those things came into being.

There's some debate as to which mortgages caused the problem:
1. Conventional loans conventionally underwritten
2. The CRA loans
3. Loans that were made when the same underwriting standards that were loosened under CRA were then applied across the board.

2 and 3 were made worse by the large number of storefront mortgage writers that sold the loans they underwrote, almost immediately. I actually think group 3 was the primary culprit. After I worked on the 1990-era S&L bailout, I felt that two changes were needed. I still think they are, and I think they would have prevented the problem. Those are:
1. Federal insurance for all CRA and like loans, funded by a half-percent interest override
2. If you package up loans and sell them, you have to keep at least 25%; with some skin in the game, underwriting standards would have improved drastically

Anyway, once those loans were in the system, anybody who had them knew (1) I've got trouble, and (2) if I can find a way to sell that trouble to somebody else then I'm okay. All of these weird derivative instruments arose out of efforts to accomplish step 2. The problem with any kind of leveraged instruments like these is that it doesn't take much of a swing to eat up your equity and cause a problem. So at least as far as the effect the financial sector, these deals really ramped up the risk. If the mortgages had performed, there would be no problem; but even a small underperformance was enough to trigger major problems becuase everyone was highly leveraged and there was little equity in the system. I think the shortage of equity capital is a major contributor, although I haven't found many of the talking heads to agree with me. We'll see how that shakes out in the future.

If these swaps and other deals had not been in play, we would have had a high default rate on mortgages that would have depressed property values. That part would have occurred in any event. A few banks with large exposure to this kind of paper (WaMu definitely, would have to guess about who the others might have been) would have gone under, and we'd have had a pretty serious crisis. Not to this level, but pretty serious. As an aside, I remember doing some strategy consulting at WaMu years ago, and telling them that I thought their strategic approach was too risky; I was dismissed out of hand at the time.

What happened is that people saw that crisis as certain, and gambled that they could work their way out of it with these weird deals, and that turned out to be a bad gamble. How similar it is to what happened in the 80s, when the gamble was moving into higher-risk loans that would pay higher interest rates; otherwise the S&L's were dead in 1980, because they were having to pay 10% to get deposits to cover home mortgages that were already on the books paying 6%. So they gambled that they could make the risky loans and the economy would have an upturn and save them. The more things change, the more they stay the same.

CRA didn't help. Fannie Mae and Freddie Mac didn't help. One motivation that I think played a factor is that since 9/11 about the only sector of the economy that has grown has been housing; if you pull housing out of the economy, there's basically no growth 2001-today. Another way to look at it is that the growth 2001-2007 was the housing bubble, and the bursting of that bubble has put us back to where we basically were in 2001. I think the Bushies went along with letting this stuff go because they wanted the economy to look good on their watch, and housing was the only game that was going, and cheap loans made that game play better.

In short, the bullet was in the gun when the mortgages that went bad were written. People took some chances in an effort to dodge the bullet; like most high-risk strategies, when they went bad they made things significantly worse.

Long post--hopefully more enlightening than confusing.

Quote:First off, if the underlying mortgages were performing, there would be no problem. None of this other stuff would matter if the mortgages were cash flowing the way they are supposed to. As a corollary to that, once the bad mortgages were made, some sort of crash became inevitable. All the packaging and credit swaps and all that stuff had a bigger impact on precisely who got taken down and when, but they didn't cause the crisis; it was inevitable by the time those things came into being.

Leverage doesn't add value, it only magnifies the outcome.

(03-26-2009 09:58 PM)STLouis Blazer Wrote:  

Quote:First off, if the underlying mortgages were performing, there would be no problem. None of this other stuff would matter if the mortgages were cash flowing the way they are supposed to. As a corollary to that, once the bad mortgages were made, some sort of crash became inevitable. All the packaging and credit swaps and all that stuff had a bigger impact on precisely who got taken down and when, but they didn't cause the crisis; it was inevitable by the time those things came into being.

Leverage doesn't add value, it only magnifies the outcome.

Good point. Actually, in this case doesn't add or subtract, just moves around. Take a chance at solving the problem, but if it doesn't work the results will be worse. And in this case, it didnt' work.