There’s a very good Economic Letter from the Dallas Fed about the housing crisis, which explains a lot about how the mess happened. In short: lenders began making lots of dubious loans in large part because they were able to slice and dice the loans and sell them off to investors who didn’t know what they were buying. My only fault with the letter is that it doesn’t emphasize the extent to which borrowers were also suckered in.

But here’s what I don’t quite understand: how could people have been convinced that all this made sense?

The dot-com bubble I sort of understand: there was a brand-new technology, nobody knew how it would work commercially, and it was possible to imagine that every startup was the next Microsoft.

But housing is housing; banks have been making mortgage loans for generations. Why was anyone willing to believe that all the rules had changed?

According to the Dallas Fed report, here’s what happened:

Two crucial developments spurred nonprime mortgages’ rapid growth. First, mortgage lenders adopted the credit-scoring techniques first used in making subprime auto loans. With these tools, lenders could better sort applicants by creditworthiness and offer them appropriately risk-based loan rates. By itself, credit scoring couldn’t have fostered the rapid growth of nonprime lending. Banks lack the equity capital needed to hold large volumes of these risky loans in their portfolios. And lenders of all types couldn’t originate and then sell these loans to investors in the form of residential mortgage-backed securities, or RMBS—at least not without added protection against defaults. The spread of new products offering default protection was the second crucial development that fostered subprime lending growth.

So a bit of financial engineering — with no new technology, no reason to think that the fundamentals of housing had changed — led to a gigantic financial bubble. Wow.

I guess hype really does spring eternal.