Not being a finance expert beyond being a homeowner and working person all I have are my impressions of what went down in the 2008 banking failures. My question relate to what incentives do banks have to be paid back money. Now and back then, how much have they changed.
The impression that I walked away with was that banks were simply selling off the loans. The people buying the loans were people using investors money and they got paid commissions right off the top. So no one really had much incentive to make a good loan. How far off am I?
The failures came because it was thought that mortgages would never fail. Mortgages were all grouped together; you could but the group and gat the income. The lenders made money selling their mortgages in a group.
But it led to bad mortgages being made, since the institution making the loan would sell it off. When the mortgages started to fail, those owning the group of mortgages stopped getting income, so the value tanked and they lost their investment. This led to failures.
That’s a little mixed up/ backwards. But your bottom line is correct: In the whole chain, very few people truly cared about quality. Until suddenly everybody did but by then it was too late.
This simplified caricature is closer to the main story:
Banks made their money mostly on the loan origination fees. So they mainly wanted to create a lot of loans. To boost volume banks hired sales agents = “mortgage brokers” who were paid a cash commission on each set of loan paperwork they brought into the bank. Both of these groups only cared about volume, not about quality. Mortgage brokers were springing up all over the country like clover in the springtime. With next to no regulation and a totally get-rich-quick attitude. Lots of truly low-quality loans got made. Loans that had only a poor to nil chance of being repaid.
Investors, including mutual-fund like pools, bought the loans from the banks under the assumption they were all quality loans with a very high likelihood of paying off. As had been true for the preceding 20-30 years.
In truth, the vast majority were of OK or better *initial *quality. But each pool of loans sold included a few of the guaranteed duds everyone was ignoring. Kinda like at the hamburger factory: If you grind up 500 cows into a single batch of burger and one cow had a massive E. coli infection you don’t end up with 1 cow’s-worth of bad burger. You end up with 500 cow’s-worth of bad burger.
Once the first loans went bad, everybody suddenly realized that *every *group of sold loans included *some *infected burger. But nobody knew how much was infected. And there was no way to pick out the infected bits. So everybody tried to panic sell their loans before everybody else sold theirs. Meanwhile banks couldn’t create new loans since their ability to sell them evaporated when all the buyers took fright.
Now the price of houses started collapsing because buyers couldn’t get loans. Which meant lots of newly bought houses were suddenly upside down. So those buyers decided to stop paying on their mortgages too. So even mortgages that were of OK quality to begin with began to turn to shit. Then the real economy starts going down, layoffs occur, etc. And now even honest people who want to pay their upside-down mortgage suddenly can’t after they lost their job.
The snowball rapidly picked up steam until it started killing the investment banks that arranged the pools of mortgages.
Of course everyone involved suing everyone else about everything really helped a bunch.