In the simplest terms, what went wrong in the sub prime mortgage market is that the people responsible for making loans had too little financial interest in the performance of those loans and the people with financial interest in the loans had too little involvement in the how the loans were made.

The capital markets are a wonderful vehicle for transferring risk and providing capital to lending activities. But when the transfer of risk leads to a lack of diligence, markets become dysfunctional. To see how this can happen, let’s start with the most basic lending transactions.

One Degree of Separation
For much of the last century, it was the savings and loans, or “Thrifts” that provided the bulk of the mortgage loans. In the traditional lending model, the Thrift raised money via deposits from its customers and then lent that money to other customers for home purchases. If the borrower was unable to make its mortgage payments, the Thrift would suffer the consequences directly. With the advent of deposit insurance, the depositors were protected and the only risk was to the capital of the institution. With limited risk management capability and limited ability to raise deposits outside of their home markets, Thrifts were subject to a boom and bust cycle that meant that capital flows for mortgage lending were uneven.

Two Degrees of Separation
The secondary market for mortgages was developed to separate the process of creating loans from the capital required to fund the loans. In the secondary market, the risk of borrower default would be transferred to an investor. Investors for the most part however, were unwilling to take on the risk of borrowers they did not know. To facilitate the availability of capital, Ginnie Mae, Fannie Mae and Freddie Mac were established. Without getting into the full history or details, the main impact of these agencies was to take on the credit risk of borrowers and allow other financial market participants to provide the funding for the mortgages. Page 2 of 6 >>>