The Cause of the Crisis: Implications for Regulation

UPDATE 05 March 2009: I would add that in light of what seems an unbelievable overextension of their balance sheet by writing hundreds of billions of dollars or more in Credit Default Swap (CDS) contracts they could not even remotely begin to conceive of being able to honor in the event, it would probably be wise to add a single rule limiting the amount of such contracts a company like AIG can write to some reasonable multiple of their capital. I also would suggest that it is most unpalatable to have the taxpayer now underwriting the counterparty risk of the buyers of these CDS contracts by making them whole with some $180B in capital injections. That is close to the entire tab for the S&L Crisis of 1991 right there. Those buyers should be out of luck and it seems rather dark that the Fed and the Treasury will not disclose those counterparties now that the taxpayer in fact owns the company.

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While people like Paul Krugman will say that the causes of the credit crisis involve many actors, and liberals point the finger at Wall Street and greedy bankers, it is instructive to remember exactly what the problem is.

The genesis of the problem is simply that millions of really LARGE loans were made to people who cannot or will not repay them.  This is not like people not paying their unsecured credit cards.   The dollar amounts involved there are small.  This is about default rates on mortgage loans going from the 1-3% range to the 15-30% range on loans whose average size is in the hundreds of thousands of dollars each.  Because the dollar amounts are so absolutely huge, they represent multiples of the capital reserves of the banking system, hence posing systemic risk.

This problem has been and will continue to be used as justification by those with other regulatory agendas to impose all kinds of burdensome and unnecessary regulations on activities from banking to trading.  Note however that the entire mess could have been avoided with but 2 simple rules relating to mortgage underwriting.

First, the lender should be reasonably sure that the normal anticipated monthly mortgage payment represents some reasonable fraction of income.  This is the Debt Service Ratio test.   Second, the amount loaned must represent no more than some maximum percentage of the appraised value of the property.  This could be as high as 90%, but probably not much higher.

Had these two simple rules been required by regulators of mortgage originators, we would not have the credit crisis we have today, even with securitisation and all the rest of it.  So be wary when you hear government say we need to regulate this, that and the other thing.  We only need 2 simple rules.

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