The government gave favorable treatment to gambling in the securities based on debt?
Yes. And I've already explained how two or three times.
But since you seem to ignore my explanations, I'll give you someone else's.
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"1. An FDIC document on the risk weights of different bank assets. The higher the weight, the more capital the bank has to hold against that asset. As I read table 1 and table 3, if you originate a loan with a down payment of 20 to 40 percent, the risk weight is 35. But if you buy a AA-rated security, the risk weight is only 20. So if a junk mortgage originator can pool loans with down payments of less than 5 percent, carve them into tranches, and get a rating agency to rate some of the tranches as AA or higher, it can make those more attractive to a bank than originating a relatively safe loan. If you want to know why securitization dominated the mortgage market, this explains it. Regulatory arbitrage, pure and simple."
econlog.econlib.org
"Recently, the main force driving mortgage securitization has been bank capital requirements. These penalize banks for holding loans that they originate themselves. Perversely, the FDIC requires banks to hold less capital against securities backed by low-down-payment mortgages originated by strangers than against high-down-payment mortgages originated by staff under the bank's supervision and control."
econlog.econlib.org
"The myth is that mortgage securitization reflects the genius of Wall Street. The reality is that it reflects the stupidity of the way that regulatory capital requirements are calculated.
The market for low-risk loans is dominated by Freddie and Fannie because the GSE's are required to hold less capital than banks for taking the same risk. The market for high-risk loans is dominated by private securitization because capital requirements encourage banks to buy securitized loans that they could never originate on their own. Freddie and Fannie were relatively minor players in the high-risk market, but what little they did undermined their safety and soundness, against the warnings of mid-level staff."
econlog.econlib.org
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Suppose that you were a bank executive and were offered a choice between two methods for holding mortgage loans. Call them Method A and Method B.
Under Method A, you employ the mortgage originators. You give them rules and instructions. You set their incentives. You can choose whether to pay them only for accepting loans or to also pay them for reviewing and rejecting loan applications where appropriate. They originate loans in your local community. The loan terms are set by your policies. You receive the borrowers' payments and deal with loan delinquencies according to your procedures. Sometimes, your procedures call for rapid foreclosure. In other instances, they dictate some sort of loan workout.
Under Method B, you hold a security interest in a pool of mortgages. These loans were originated by people unknown to you, whose only incentive is to maximize "production," without regard to quality or risk. They are paid when they originate a loan, never for rejecting a loan application. The loans come from far and wide, including many places with which you are not familiar. If borrowers are delinquent in their payments, you have no control over how this delinquency is addressed.
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The securitization process so bamboozled the regulators that banks were holding securities backed by high-risk, low-down-payment mortgages that had been rated AAA, and thus had a risk capital weight of 0.20, which is significantly less than the 0.35 risk weight given to a low-risk mortgage with a 40 percent down payment originated using Method A. The regulators were telling banks to treat Method B mortgage loans with low down payments as safer than Method A loans with high down payments.
As home prices rose, it became more and more difficult for borrowers to come up with 20 percent down payments, causing the proportion of conventional mortgages to shrink. As private securitization increased in importance, Freddie and Fannie saw their market shares, which had peaked at 50 percent in 2003, start to decline. Moreover, the segment of the market they were left with was increasingly upscale, so that political leaders began to berate Freddie and Fannie over their lack of support for "affordable housing." The pressure built on Freddie and Fannie to join in the high-risk lending frenzy, and they caved into that pressure.
News reports show that at both Freddie and Fannie, warnings were issued by staff about high-risk lending. The stress test methodology required the firms to dedicate large amounts of capital for these loans in order to protect the firms in case of a downturn. Not wishing to abandon the high-risk market or to dilute earnings by raising the capital called for by the stress tests, the CEO's at the two firms simply over-rode staff objections and dove into the market, without raising the requisite capital.
Freddie and Fannie were never the dominant high-risk lenders. Nonetheless, they took on more risk than they should have, with less capital than was prudent. Had they maintained a focus on safety and soundness and stayed out of high-risk lending, the firms would done less to inflate the house price bubble. Freddie and Fannie would be in good shape now to pick up the pieces of the faltering private securitization market. Instead, the two firms themselves required a taxpayer bailout.
Finally, it is important to bear in mind that Freddie Mac and Fannie Mae were part of the Method B mortgage lending process. If capital requirements had been rationally tied to risk and applied equally to all institutions, Method A lending would have driven method B lending out of the market. Freddie and Fannie would not have grown to dominate the market. Instead, my conjecture is that they would not have been able to gain even a toehold in a free and fair market. Mortgage securitization is entirely a product of regulatory distortions.
The regulatory distortions were by no means accidental. Often, the regulatory loopholes were pried open by lobbyists working for Freddie Mac, Fannie Mae, or Wall Street firms that profited from securitization. Key members of Congress were generously plied with campaign contributions, in return for which they championed securitization and emasculated the regulators who oversaw Freddie Mac and Fannie Mae...
econlog.econlib.org
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Of course securitization was only part of the problem, but government did indeed reward securitization over alternatives. And other government policies helped inflate the bubble.
Not that bubbles don't occur without government help, just that this one didn't.
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And just as bubbles can form without government help (unlike this one) they can form with securitization (unlike this one)
"The problem is not securitization. The problem is that when house prices are going up, there is no such thing as a bad loan. Even a loan where obtained by total fraud will work fine if the price of the house goes up.
In the mortgage market, people saw risk-takers outperforming prudent lenders. So they took more risks. There is no simple fix for that. For the foreseeable future, we can count on investors sticking to prudence when it comes to mortgage lending. We don't need any regulations to close that barn door.
But somewhere, some time, in some other market, there will be another outbreak of excessive risk-taking. You can't make the system idiot-proof. They'll just build a better idiot."
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