This financial collapse never had to happen, if we had properly regulated the mortgage market. And the ideological opposition that bankers had to regulation was obviously short cited; if we had, everyone—including the bankers—would have been better off. This is how ...

For the last several years, overzealous 20-somethings who worked as mortgage originators put everyone they could find into mortgages, regardless of what was in their best interest, because they worked on commission and collected a fee for each mortgage they originated. And since they immediately sold those loans to firms that would package them into pools and sell them as collateralized debt obligations in the mortgage backed securities market, they had absolutely none of the downside risk; it’s no wonder they didn’t care about the borrower’s credit worthiness. In fact, there was even an incentive for them not to fully document the borrower’s ability to repay the loan, because that meant they could resell the loan for a higher value because of the assumed quality of the borrower.

Even more perverse is that they had an incentive to put unsophisticated borrowers into non-conforming financial products (like three-year interest only loans, or three-year balloon payment loans) that borrowers didn’t understand. The 20-something mortgage originators thought that would be just fine, as they figured the borrower would be forced to come back to him/her to refinance in three years after their monthly payments readjusted (at which time they could collect another fee and sell another loan). At that time it was assumed that real estate values could do nothing but appreciate, until real estate developers started to build too many houses and oversupply the market. When prices began to slip and three-year interest only mortgage payments readjusted, millions of borrowers were stuck in loans that they couldn’t afford and that they couldn’t refinance because some kid told them that that particular financial product would be best and not to worry.

And who bought up all these loans? The banks did, especially the ones that failed (Bear Stearns, Lehman Brothers, Merrill Lynch, etc.). One might ask why they would be so stupid as to buy such shoddy debt assets? Well, those firms outsourced their most core competency — risk management — to firms that had an incentive to overvalue the underlying assets that they were being paid to value and price (Fitch’s, Moody’s, etc). They charge a fee to value these assets that was scaled to the size of the asset they were valuing; if they gave an asset a higher rating, they would receive a higher fee. So they didn’t ask questions when mortgage originators sold loans that weren’t fully documented. Now, a thinking person would ask, “If this person wants to buy a house, why didn’t you ask them for their W-2s?” But a person who was engaged in implicit fraud, would think to themselves, “Great, we can just assume that this is a triple-A loan too,” the sounds of “cha-ching” ringing in their head lusting for their year-end bonus.

Now, if you talk to a VP at one of the rating agencies, they’ll tell you that their valuation models incorrectly valued risk at the confluence of two default risks which, they say, should have been calculated logarithmically but were instead calculated arithmetically: 1) the risk associated with unsophisticated borrowers, and 2) the risk associated with non-conforming financial products. That’s a lie. It was implicit, unspoken fraud (unless, of course, they were too stupid to understand what they were doing). In addition to that failure, which severely underestimated default rates, they also built in prepayment assumptions that were highly overoptimistic. Essentially, they could make the price of a mortgage backed security whatever they wanted it to be, regardless of the underlying debt assets. And the investment banks who were chasing returns (and the bonuses that accompanied them) turned a blind eye.

And all of this could have been prevented if we just regulated those over-zealous 20-somethings. The global financial collapse wouldn’t have happened. Bankers — along with everyone else — would have been better off. Is it too burdensome a regulation to ask that you show your W-2s or (heaven forbid) your tax returns when you want buy a house? Hardly.