by Calculated Risk on 9/26/2009 04:06:00 PM

From the WaPo: Barney Frank Talks Back A couple of excerpts:

Klein: What's the most important part of financial regulation?

Frank: Limiting securitization. I believe the single biggest issue here is that people invented ways to lend money without worrying if they got paid back or not by securitizing the loan. When I was younger, the theory was if you had a high risk tolerance, you went into stocks. If you were safe and stodgy, you bought debt. But debt became the volatile aspect here.
...
Klein: One theory of the crisis is that the problem wasn't traders and their high tolerance for risk. It was people fooling themselves into thinking this stuff was safe by slapping a triple-A rating on everything.

Frank: I agree; the theory has always been that people bought debt because it was safer. The basic problem was that 30 years ago when people lent other people money, they expected to be paid back by the people they lent money to. So they were very careful. Two years ago, most loans were being made by people who were going to sell those loans to other people and didn't expect to be paid back.

This is an interesting answer. About two years ago, I was asked to sum up the causes of the crisis in a few words, and I responded "Securitization and the lack of regulatory oversight". I then explained how rapid innovation in lending resulted in a disconnect between the borrower and the eventual debt holder.

The mortgage lenders and Wall Street firms were disconnected from the performance of the actual loan (the "Originate-to-sell" model). At the same time, the rating agencies were evaluating the debt based on the historical performance of the old style lender-borrower relationship. The eventual debt holders relied on the rating agencies, without realizing the entire model had changed.

Meanwhile the regulators were not following this advice:

“Instruct regulators to look for the newest fad in the industry and examine it with great care. The next mistake will be a new way to make a loan that will not be repaid.”
William Seidman, "Full Faith and Credit", 1993.

There is nothing inherently wrong with securitization or financial innovation. But the regulators should always be on the lookout for "a new way to make a loan that will not be repaid".