What Went So Terribly Wrong
At the risk of oversimplification, it began with financial institutions seeing an opportunity to do some good things by:
- Writing or otherwise generating mortgages to less than normally qualified home buyers, anticipating returns sufficient to cover the expected higher default rates.
- Packaging the debt obligations in ways that spread the risk, thereby presumably lowering the risk, and then selling the paper to a range of investors.
- Allowing those who otherwise would not be able to achieve the American dream of home ownership to do so and to build equity for their families.
And, of course, they would make some very good money in the process.
On the surface, it all sounds pretty good. One can readily see why so many of the U.S.-based and international financial institutions got into the act. Some were initiators, some jumped on the bandwagon as it was rolling along, and some eagerly invested on the other side of the equation.
Cutting to the Core
Some government officials following the happenings warned of a coming crisis, and astute investors did indeed see the true risks and stayed on the sidelines.
What did they see? That the players in this process were making several fundamentally flawed and related assumptions: that spreading the risk would lower the risk, that the returns would be sufficient to cover the higher default rates, and—most significantly—that the housing market would continue to rise in value forever.
That last point is the key. As long ...