How the Mortage Crisis happened...

[acroyear]

Good Math, Bad Math : Mortgage Basics (part 2): The System is Broken.:

The way that [the mortgage system] works is:

1. Someone who wants to buy a home goes to a mortgage broker, and fills out an application.
2. The mortgage broker takes the application, and brings it to a lender. The mortgage broker is generally paid a commission by the lender for bringing them the potential loan.
3. The lender gets applications, and decides whether or not to give the loan. Once the loan is given, they sell the loans. They make money by selling the loans.
4. Investors don't buy loans directly. So there's another intermediate - an agent who buys mortgages, bundles them together into groups, and then sells bonds based slices of collections of mortgages. The mortgage bond agent makes money by selling mortgage bonds.
5. To supposedly manage risk, people like to buy bonds based on the best loans. That leaves a lot of leftover. Investors buy up bonds based on the best parts of the mortgage clumps. The remainder are sold to another kind of agent, who takes the leftover parts of the mortgage clumps, and combines those into a meta-bond, called a collateralized debt obligation. Those CDOs are then sold to investors. There's an elaborate system by which potentially risky mortgages are repacked into supposedly high-quality investments. I spent some time describing that system here.

There's a big problem with the structure of this system. Each intermediate participant in the system makes money by selling the loans to someone else - so they make money not by earning interest on loans as they're repaid, but by selling the loans before any payments are even received. So none of them are personally at risk if the underlying loans can't be repaid.

Worse, each intermediate in the system can plausibly claim that they are responsible for checking the information used to decide whether to approve the loan or not. The mortgage agent just fills out paperwork; he's just a facilitator. He's not really involved in the loan; even if he checked the information on the application, the lender should recheck it anyway, so why should he do it? The lender argues that they don't get to see the borrower, just the information that the mortgage broker gave them; he's their agent, he should have made sure that they got correct information. The investment agent that bundles loans into bonds argues that the lender was responsible for assessing the risk of the loans, and was supposed to give them valid, checked information. Each participant knows what a farce this is; each one knows that the other parties aren't doing the checking that they should. But each one is making money, hand over fist, by not checking things, and they've got a plausible excuse for denying their own responsibility.

emphasis mine