Virtuality and the Financial Crisis: Part 2

Corrective measures envisioned by lawmakers in the heat of the financial crisis are directed toward strengthening oversight of financial markets. The regulatory system including the Federal Reserve, the Securities Exchange Commission, and other Federal agencies collectively may have been unable to detect the formation of a speculative bubble in the housing market; or perhaps the system detected problems but failed to act on a timely basis. Interest rates could have been raised to reduce the amount of credit available for house purchases, and abusive lending practices could have been curtailed giving potential buyers more accurate information about their ability to carry a mortgage, and thus reducing the chances of defaults and foreclosures later on.

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.

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Virtuality and the Financial Crisis: Part 1

The financial crisis that began in 2007 and reached fever pitch in the past few months is generally believed to be a consequence of the securitization of subprime mortgages and more generally of the over extension of credit. Participants in this tragic drama include actors in the real estate and financial services industries as well as home buyers.

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.

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