Overhauling and strengthening regulatory oversight of financial markets is a sensible step, but not enough to prevent a recurrence of the frenzied pursuit of profit that precipitated the crisis. Not all mortgage lenders succumbed to the lure of higher profits through securitization of loan portfolios.

Many local and regional banks, for example, continued doing business as of old. They held to the traditional policy of making prudent loans to qualified borrowers in their communities, and keeping on their books the mortgages they issued to home buyers. Such policy acts as a brake on greed by underscoring the lender’s interest in making sure potential borrowers can repay their mortgage loans; it also reinforces prudent behavior on the part of realtors and appraisers because the lender needs a realistic assessment of the market value of a house as collateral for a loan. Moreover, by insisting on documenting income sources, traditional policy reinforces the honest behavior of borrowers.

The essence of traditional policy is a direct connection between lender and borrower. When that connection is broken by securitizing mortgage assets, the incentive for actors in real estate and financial services to act prudently and ethically is substantially weakened.

A marketable security based on mortgage assets is an abstract financial instrument that carries no information about borrower and lender. An investor who purchases such a security is concerned only about its current price, potential for future price appreciation, and the dividends it pays. There is no direct relationship in the financial marketplace between borrower and investor or between lender and investor.

The parties to a real estate transaction are related to each other only by the formal roles they play in the transaction; the informal relationships that are essential to reinforcing appropriate behavior in any group are entirely absent. So, it is not surprising that predatory and abusive lending practices had become widespread, and that lenders were less than eager to meet with financially strapped borrowers to resolve problems.

The set of relationships defined by a real estate transaction has come to resemble a virtual team in which the members are place markers for required roles. Each role – agent, broker, lender, and borrower – can be played by one individual today and another tomorrow. Ideally a virtual team shares a common purpose. The parties to a real estate transaction may or may not have a common purpose. Be that as it may, even if there were a shared goal, it would be extremely difficult to ensure that each member of a virtual team contributes to that goal to the best of his or her ability, since personal relationships are weak or non-existent.

If transactions in the financial marketplace continue to reflect the kind of disconnection prevalent among the individual and institutional actors in the real estate bubble, the absence of effective mechanisms of social control evident in virtual teams will inevitably facilitate new crises in the future.

The process of purchasing a house consists of a long chain of transactions starting with a ‘meeting of the minds’ of buyer and seller, usually mediated by a real estate agent representing the seller. Once an agreement has been reached, the buyer must arrange financing. Here is where the trouble starts.

Let’s say the buyer uses the services of a mortgage broker to find a bank or other lender willing to issue a mortgage on the house. Having no responsibility for the future behavior of the buyer, and receiving a fee for its services, the mortgage broker’s interest is to place as many mortgages as possible. Real estate agents and property appraisers have a similar interest. Both work on fees or commissions based on sales, so their aim is to generate as many sales as possible.

In the ‘old’ days – before the housing bubble of the past decade – the bank or mortgage company issuing a mortgage on a given property would generally hold the paper until the debt was discharged. This relationship between home buyer and lender changed as mortgages were bundled into pools of financial assets to be securitized and sold. With securitization the lenders’ interests became aligned with those of realtors, appraisers and mortgage brokers.

Commercial banks and other mortgage originators realized they could increase their profits through securitization. By using pools of mortgages as assets for new classes of securities, and selling these securities to investors, additional funds could be made available for yet more lending. Investment banks entered at the end of the chain to package, underwrite and sell the mortgage-based securities to investors.

None of the actors in this chain was overly concerned about the borrower’s ability to repay a loan. Borrowers’ equity increases when house prices rise. Under these conditions even subprime borrowers could cope with adjustable rate mortgage resets by using the additional equity to refinance their loans. Alas, all good things must come to an end, and house prices cannot rise forever. When prices ceased to rise, and adjustable rate mortgages reset higher, many subprime borrowers could neither make their payments nor refinance their loans.

Mortgage holders started a wave of foreclosures that eventually depressed house prices by increasing the inventory of houses on the market. The wave of defaults and foreclosures led to price declines for mortgage backed securities, and suddenly major financial institutions had to take write downs on billions of dollars worth of securities on their balance sheets. This led to the collapse of major financial institutions and necessitated intervention by the Federal government.

A vast amount of ink has already been spilled on this issue, so why retell the story here? Missing from the picture painted by the media is the underlying cause of the debacle. No doubt greedy and unscrupulous lenders, real estate agents, property appraisers, mortgage brokers, commercial and investment bankers and rating agencies, together with irresponsible borrowers are the villains of the piece. But greed and irresponsibility have always been with us and these human traits are not likely to disappear any time soon. It is necessary to identify the greedy, unscrupulous and irresponsible parties, but such identification is not sufficient to prevent a recurrence of similar behavior in the future.

To be continued in Part 2 …