I was watching the a show on the sub-prime mortgage meltdown today on CNN where they discussed in detail what went wrong? Why did it happen? Who’s responsible? blah blah blah. It was a pretty interesting discussion with the so called ‘experts’ in the concerned fields. For those who are not aware of the how the meltdown took place, let me give you a brief in the following paragraphs.

In 2004, interest rates hit rock bottom and at the same time, the US began to recover from the IT bubble burst. Banks found themselves loaded with cash and were waiting to offload them. But people were already earning a good amount of money since the economy started recovering. So what did they do?? Simple. Target the one’s who don’t have houses. Market it to them that their life long dream of having a huge house can become reality because they had a magic pill for it. Of course, they don’t tell you that this pill has some side effects. Most of these loans had a flexible interest. That means that if the interest rate increases, your monthly installment. If for a 4% you pay $2000 and the interest rate goes up to 8% a couple of years later, then – BANG!!! – you now have to pay $4000 a month. But how do you make sure that people don’t realize it? Another simple solution is to have the interest rates fixed for the first 2 years. Most people don’t see too much in the future and the minority groups who were never given a loan in their life had no idea that something like that even exists. They all dived into taking loans and the greedy load agents helped in every way they could including over stating their incomes, financial background and their payments of past loans (if any).

This started a real estate bubble. The sudden demand for houses due to easy availability led to an increase in house prices. As in any bubble, people tend to buy when during the bubble when the price is increasing in order to be a part of the lemming parade.As people started taking the loans, traders wanted to trade these “mortgages”. So what they did was collect various mortgages and convert it into a package. This package was then securities so that it can be traded. But to be traded it had to be given a credit rating. These so called “Securitized Mortgages” had a mix of loans some of which were low risk (meaning that the probability of the borrower paying his interest dues are high) and others were high risk (meaning that the probability of the borrower paying his interest dues are low). But again traders were smart enough to make these packages as complicated as possible.

Financial Instruments can become so complicated that only a handful of people can understand their working. (The fate of Long Term Capital Management has shown us that event noble laureates are incapable of fulling understanding the workings of financial instruments). The credit ratings agencies gave these “packages” a good rating since they had low risks mortgages. This set up a wonderful house of cards ready to fall anytime. These packages were traded and brought by banks since they thought it was a good one. After the two year time period, the interest rates sky rocketed since the duration of the fixed interest rate was over and the era of flexible interest rates had begun. Suddenly people earning just $1500 a month had to pay $2500 as interest on their loan. Common sense tells you that there is going to be a default on the loan repayment. However, as per the mortgage contract if the loan was not payed back in time, the bank would auction the house to raise the money. In order to avoid this scenario, the borrowers started selling their houses.

The age old theory of supply and demand tells you that if demand is more prices escalate while is the supply is excessive prices fall. This was not exception and the real estate bubble that had developed since a long time was not ready to burst. This was the last puff of air to blow the house of cards away. Interest rates were high, your house is worth half that it was a couple of years ago and you have no money, yet you have to pay the high interest rate associated with the flexible rate interest. Most of the law income minority groups defaulted in their payments for months on a row. Banks suddenly realized that their mortgage assets are worth half their value. The result – huge write offs by banks which has amounted until now a mammoth $150 Bn. Banks seized the houses of the defaulting borrowers and auctioned them. Though they managed to get a part of the money back, their losses were huge. This where we currently are. Many people lost their houses while banks have claimed huge losses. But who’s fault is this? Why did such a scenario develop? Can this happen again? I have put thought to this myself and have come up the conclusions that I have explained in the following paragraphs.

As humans we are selfish species. This is because incentives matter a great deal to us. Anything that is not a incentive to me is not worth doing. The complete cycle that I have stated above can be explained through the theory of incentives. The lenders initially had an incentive of providing loans to the low income groups for housing so that they can off load their assets. Most of my Indian readers would have noticed this phenomenon a couple of years ago when loans were aplenty and it was normal to receive 10 phone calls a day from banks wanting to sell you loans. However, banks don’t sell these loans directly. It is done through agents.

Now for these agents are paid based on the amount of loans they have been able to sell. Generally banks are not meticulous in placing minimum quality requirements for these loans. Thus they have a different incentive from that of the bank. Thus they go to any extent to make sure that you take the loan even if this means lying or making fraudulent entries in their forms. They also make sure that you don’t read the contract so that you don’t point of issues and spoil their chance of making money. Further, their role ends once they have sold the loan. So they are interest in whether the bank will make sure that you have your home come what may or that the loan payments are sustainable by you. This is one point that frustrates me deeply. The agents incentives are not aligned with those of the banks or the customers and neither is he responsible. The result – he lies to you so that you buy and then runs away with the banks money. I believe that they should be made much more accountable so that their quality of work improves.

Now lets of the next individuals – the traders. The main aim of traders is to sell and buy. The more they do, the more commission they earn. So again, their incentive is not aligned to those of either the banks’ or the borrower’s. So they package these mortgages so that they are priced more than they are valued. They trade and finally some bank ends up with this package of good and bad loans and the rest is history.

So given this, who should be held responsible for the losses? i believe that you cannot burden the end borrowers who do not understand what they have got into. The banks that initially lend these loans should be held responsible. It was their responsibility to see that their agents were qualified and ethical enough to sell the loans. This was the root of the problem and if addressed would not have caused a meltdown like this.