Why Markets Cannot Be Relied on to Police Themselves

Prudent Bear has put it better than I ever could^* in his post, When markets lose their mind.

His point:

Subprime mortgages themselves exemplify irrational markets, yet the participants’ activities at each stage were economically in their own rational interest:

• Low income consumers took on mortgages they had no prospect of affording because they believed from the experience of others that house prices would rise sufficiently to bail them out. In any case being often near bankruptcy the potential profit from successful speculation appeared to them greater than the potential loss from default.
• Mortgage brokers sold subprime mortgages because they got a commission for selling them and were not responsible for the credit risk.
• Investment banks packaged the subprime mortgages into multiple-tranche mortgage backed securities because they received fat fees for doing so and again had no real responsibility for the credit risk.
• Rating agencies gave the upper tranches of mortgage debt favorable ratings, because they made a great deal of money from providing ratings for asset backed securities, needed to keep in the favor of the investment banks who brought them this attractive business, and had mathematical models (either their own or the investment banks’) “proving” that the default rate of the securitized mortgages would be low.
• Investment bank and rating agency mathematicians produced models “proving “ that default rates would be low, ignoring the real-world correlations between defaults on low quality consumer debt, because they were well paid to do so – the alternative was to return to a miserable cheese-paring existence in academia.
• Finally the investors bought asset backed securities because they could achieve a higher return on them in the short term than their borrowing costs, and could tell their funding sources (in the case of hedge funds) or bosses (in the case of foreign banks) that they were taking very little risk because of the securities’ high rating.

I do think that his post is incomplete in one area, which is in explaining how so many people with decent credit got caught up in this too.