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Foreclosure-Gate: Why Was There Demand for Bad Mortgage Loans?

The obvious answer is that good loans did not generate hugely excessive bonuses, but bad loans did. What happened is that the benefits for originating bad loans exceeded the cost of these negative consequences – someone was paying enough more for bad loans to overwhelm the normal economic incentives to resist such bad underwriting. The best example of this is John Paulson, who earned nearly $20 billion for his fund shorting subprime. This amount of money was not ever possible or conceivable in the mortgage business prior to that point. The only way it could occur was through the creation of a tremendous number of bad loans, followed by a bet against them. Betting on good loans could never generate this much gain. Given the massive amount of money earned by betting on bad loans, the logical next step is to ask, how did such incentives affect and distort the market? Remarkably, the report never asks such a question. Yet the FCIC learned from Gregg Lippman of Deutsche Bank, who was arguably the single most important individual in developing the market for credit default swaps on asset backed securities (which allowed short bets to be placed on specific tranches of mortgage bonds) and related “innovations”, such as the synthetic CDO (a collateralized debt obligation consisting solely of CDS, nearly all of which were on mortgage bonds) that he helped over 50-100 hedge funds bet against bad mortgages. Didn’t it seem obvious to anyone at the commission that this information meant that a tremendous amount of money was invested in the market failing? What was the impact of this pile of money?

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