To understand the problems inherent with securitization, imagine that you are a bank executive faced with two alternative routes for obtaining mortgage loans—a direct route and an indirect route. In the direct route, your loans are originated by your own staff. You establish standards, policies, and procedures for loan origination. You choose the markets in which you would like to originate loans, and you will probably focus on communities where you know the local economy. You hire and train personnel to follow internal guidelines.
Your compensation policies incorporate incentives for them to accept or reject applicants in accordance with company policy. Once the loan has been made, if the borrower misses a payment, your staff follows company procedures for contacting the borrower and resolving the problem.
In the indirect route, loans are originated by persons unknown to you, following guidelines established by someone else. The loans may come from communities with which you are totally unfamiliar. The originators may very well be paid on commission, which they can only receive if they close a loan—never if they reject an applicant. If the loan gets into trouble, you will have no control over how the delinquency is handled.
No sane bank executive would choose the indirect route over the direct route. In economic jargon, the "agency costs" of the indirect route are prohibitive. The originators of mortgages in the indirect route are operating under incentives that are contrary to the bank's interest. The misalignment of incentives between the bank and those acting as its agents in the indirect route will force banks to incur additional costs to monitor and review the work of the originators. Even with most diligent efforts, the bank is likely to incur higher losses from defaults, as originators squeeze bad loans through the cracks of the bank's monitoring systems.
It is surprising, therefore, that as of 2008, nearly three-fourths of mortgage debt in the United States had been originated using the indirect method. To reach this point required a combination of Wall Street ingenuity and regulatory anomalies.
I like this part too:
The suits treated mortgage securities as bonds, ignoring the power of the embedded options. In August and September, when policymakers began to perceive the severity of the crisis, the suits thought that mortgage securities could not possibly have lost as much value as their market prices indicated. Federal Reserve Board Chairman Ben Bernanke insisted that if the securities were "held to maturity" that they would have higher values. Treasury Secretary Henry Paulson proposed to have the government buy and hold these securities in order to "unclog" the financial system. However, this thesis, which in effect was arguing that the geeks had mispriced mortgage securities, proved to be incorrect. The banks that had invested heavily in these securities were truly under-capitalized. The mistakes had been made by the suits, not the geeks.
I always wondered what finance was really about, or rather why it has become this huge behemoth, representing some 40% of U.S. profits. Now I think I know. It's kind of like law, in that the big money is in finding novel ways to subvert the law, causing more laws to be created, and more opportunities for subversion, etc. Looks like a big part of those profits are nothing more than rent seeking.
This also makes me think that no amount of regulation will ever fix the problem, and that maybe the Austrians are right: we should return to competitive banking.