It all started years ago when poor legislation was passed along, driven by the influence of powerful lobbyist who had a handful of congressmen and senators in their back pocket.

This legislation allowed for the creation of financial instruments that operated outside of tradition governance and exceeded the capabilities of our financial system.

Then, the high profits induced others to enter the market, which is rational economic behavior, but increased the risk as more and more companies, funds and securities became tied together. And once it all came unwound, people (read pundits and politicians) searched for an easy answer that the average Joe would grasp unto and by into and in this case, that answer is the simplistic and stupefying "Greed".

Don't get me wrong - greed was a factor with some of the individual actors, but greed is not what happened here. And that level of thinking by people whose finger prints are all over this issue demonstrates the level of their arrogance, contempt and outright abuse of the system and the taxpayer.

On the other hand, should we remain actively ignorant of what our elected officials allow and do, while we amuse ourselves watching "American Idol", we have no one to blame but ourselves as we slip to second, if not third world status

posted September 21, 2008

I suggest you read "Liars Poker" by Michael Lewis to gain insight into how this happened. In a nutshell changes were made to U.S. laws that facilitated the creation of a secondary market for mortgage backed securities. Prior to these changes mortgage companies wrote and serviced mortgages. This meant that if bad loans were made the firm was on the hook. After the changes loans could be sold and traded.
Wall Street created Mortgage Backed Securities
where thousands of mortgages were pooled and organized into "tranches" so that investors could buy bonds backed by mortgages that matches their risk reward profile. The tranches were setup such that only after all the mortgages in the highest yield tranche had defaulted were investors in the next tranche exposed to default risk. Eventually the last tranche was considered to have a zero default risk and thus was given a AAA rating from the ratings agencies. Firms like Bears Sterns made so much money selling CDO and MBS that even when then could no longer sell the AAA bonds they continued to create more MBS and just put the AAA notes into inventory and sold the higher yield notes. Basically risk management was non-existent in these firms. The investment banks continued to report record earnings but they carried immense hidden exposure to U.S. residential real estate market. Once the "sub-prime" problem became common knowledge investors and regulators started asking questions and these once great investment banks started to unravel.

posted September 21, 2008

note that CDOs were used two decades ago during the S&L crisis to unload toxic properties (obfuscating actual value from the buyers).

long-winded, decade old post discussing many of the current problems (including obfuscating CDO-like instruments):
http://www.garlic.com/~lynn/aepay3.htm#riskm

In the past, mortgage originators (typically regulated financial institutions using funds on deposit at the bank) had a vested interest in paying attention to loan quality. getting triple-A rating on toxic CDOs allowed unregulated mortgage originators to immediately unload all the loans they could write, effectively eliminating any motivation for mortgage originators to pay attention to (or manage) loan quality.

As a result, there were large number of no documentation, no down payment, 1%-2% intro rate ARMs, possibly interest only payments. These were gobbled up by speculators ... anticipating flipping the property before the rate reset.

On the other side of the triple-A rating, institutions were heavily leveraged buying up all these triple-A rated toxic CDOs (some claim that GSEs were leveraged 80:1 with toxic CDOs, i.e. only had a little over one percent capital actually invested).

There was business school article from last spring claiming that possibly 1000 executives are responsible for 80% of the current mess and it would go a long way to fixing the problem if the gov. could figure out a way for them to loose their jobs.

There seems to be a separate problem with financial reporting ... despite SOX. GAO is now doing a database of increasing number of companies "restating" financial numbers ... basically the top executives get bonuses based on the original numbers ... but don't have to forfeit the bonus after the restatement. Freddie did get fined $400m in 2004 for $10bil inflated statements and the CEO replaced .... but the CEO got to keep tens (hundred?) of millions in bonuses.

Links:

• http://www.garlic.com/~lynn/aepay3.htm#riskm
• http://mysite.verizon.net/vodkajim/housingbubble

posted September 21, 2008

Several great answers to your question. In the end, it all comes down to corporate governance, profits, risk management and also macro economic policies.

posted September 21, 2008

The New York Times has an interesting article regarding the failure of risk management systems in the financial institutions affected.

Links:

• http://bits.blogs.nytimes.com/2008/09/18/how-wall-streets-quants-lied-to-th...

posted September 21, 2008

I remember the first topic in economic class was a simple sentence, “men is selfish.” It starts out our economic model, or let say capitalism. According to Karl Marx saying, this feature of capitalism would turn it to the end. Afterward, it would be socialism, or further, communism.

To the question of the situation nowadays, it is no question to say it is mostly due to greedy. We all eager to get more money as we can. In fact, we are all fall in the trap of capitalist. Ironically, their traps harmed themselves in turn. Thanks to liquidity flow, banker could invest $3 dollar and brought $20 business returns. Huge amount of profit induce our ultimate bad side, greedy. Then they started to take higher risk and dishonest in order to gain more revenue, such as put $3 cost and earned $50 or much more. There is no free lunch in the world. They rewarded unexpected earning last year by the cost of fake and immoral way of investment. Once we nail the lie, they are forced to pay back an immense cost.

posted September 22, 2008

I don't think it has anything to do with greed. I assume that bankers have been just as greedy in the last few years as they have always been, but something allowed them to express their greed. If we take their greed as a constant then it could not possibly explain something that changed.

Corporate governance played as much a factor as uneducated borrowers.
Milton Friedman while teaching at Chicago said that we must never underestimate the human spirits willingness to avoid the rules if gains are to be made. The history of banking regulation in the United States has been one of cat and mouse. Where the innovations of financial engineering in search of regulatory avoidance and profit maximization creat new rules, which in term create new opportunities to avoid these rules and so on.

Why do you think that in the United States in the 1970's banks gave away toasters, t.v., and other appliances? It was in their attempt to avoid the laws governing ceilings on the interest that could be charged on deposit accounts. This way your gain from an account with such a generous bank would be in the form of a toaster...sounds like that is just an indirect form of interest to me. Why is it that after the introduction of rent control, appartment managers charge key deposits, obsene credit report charges, or simply 'administrative fees'? It is their way of extracting rent when it is economically feasible by avoiding the formality and illegality of increasing rent in a way that violates rent control laws. The examples abound in contemporary history of business regulation.

To answer your question in a more direct manner. I would say that the cause of all of this mayhem is the accelerated changes to the financial industries and the incompetence of regulators in keeping pace with the innovations. The cat and mouse game of economic and financial regulations got away from the regulator. This effect was exacerbated by the growing internationalization of financial markets.

posted September 22, 2008

It is a mess, and a combination of the first three of your quesitons. BUT - from the ashes there are great opportunities developing. Stressed Mortage advisor, Litigator, and more importantly to me, Equipment Leasing Broker! The banks are just too scared to lend money now. If they do, it is with a huge down payment that most businesses cannot come up with. That is where equipment leasing comes into play! There is a minimal outlay of capital, flexable payment plans, and I must say, a lot of money to be made. The pent up demand is extraordinary!

Links:

• http://www.canyonleasing.com

posted September 27, 2008