April 26, 2007, 10:25 am

The current failures in the subprime mortgage market, both of borrowers and lenders, has become one of those classic Rorschach tests where people self-identify by what description they apply to the market fallout. Views on capitalism, free interchange, and individual responsibility are all tied up in the choice between:

Businesses recognized an opportunity to expand the mortgage market by offering mortgages to poorer, riskier borrowers and managing the risk by securitizing these loans and reselling them in the increasingly robust institutional market for such loan packages. While certainly in it for the profit, this move was consistent with the long-term trend in the US to wider home ownership. It turned out, however, that almost everyone involved were working off some poor assumptions. Borrowers over-estimated their ability to pay and counted too much on the continued upward trajectory of real estate values. Lenders made a number of bad credit decisions, something not wholly surprising in a new market. And institutions and other investors under-estimated the risk in these packages, particularly the systematic risk associated with falling housing prices. The sub-prime market will likely re-emerge, but with everyone smarter the next time around. Huge losses give lenders and institutions all the incentive they need to change their behavior in the future.

-- OR -- Unscrupulous lenders created the sub-prime market as a way to make a quick buck off of naive and inexperienced borrowers. They tricked these borrowers into taking on more debt than they could handle in order to get large up-front fees. Institutions were not arms-length investors, but were explicitly knowledgeable and "in on" this con. Their goal was to sell worthless bonds to unsuspecting investors. The fact that the lenders and institutions are taking the biggest losses in the market collapse is not a sign that they are innocent, but that the market fell apart faster than they expected, so they had not had the chance to unload the securities on duped individual investors. Without regulation, lenders and institutions will continue committing these same crimes and poor people have proven that they need outside help to make good decisions with their money. Congress needs to step in and prevent poorer borrowers from being offered mortgages in the future, and institutional investors need to be held financially accountable when borrowers take on more debt than they can handle.

Update: There are several comments that say "can't it be both?" Surely there can be simultaneous examples of both in the same market, but, as an example, proponents of #2 talk as if theirs is the dominant explanation, and are proposing legislation on that basis.

Recognize that you have to really believe #2 all the way to even consider some of the draconian measures that Congress is entertaining. There is legislation that is being seriously considered at this moment

that will fundamentally change the entire mortgage market, not just the

sub-prime piece, for the worse. In particular, Congress is considering making financial institutions that invest in securitized batches of mortgages liable for any illegal lending practices of the originator. This will effectively kill the securitization process. Many of you younger folks won't know what that means, but in effect it will send us back to the mortgage process of the 1970's, which I promise you really, really sucked. This will make it much harder for everyone to get mortgages. Since securitization, there are an order of magnitude more mortgage competitors, the mortgage approval and application process take about 1% of the time it used to, rates are lower, and there is much more flexibility in mortgage design.