I will let here Dr Louis Gagnon, professor at my Alma Mater (Queen's University in Kingston, Ontario), describe the principle:
"Under this new business model, prospective home owners with no cash to spare and no confirmed income stream would be lured into the pipeline, with adjustable rate mortgages (ARM) serving as bait, by an army of slick mortgage brokers, the first fee-takers in the chain. Then, the mortgages would be put into a big pool and securitized by an investment bank, for a fee. This process would involve the establishment of a special-purpose entity (SPE), some sort of trust that is “technically” independent of the parent, to purchase the assets from the pool. More fees! This would insulate the parent from the usual regulatory capital charges applying to plain vanilla loans. Regulatory capital arbitrage! The purchase would be financed by selling the income stream from the pool in the form of CDO tranches to a bunch of investors, the hedge fund kind as well as the naive kind. This way, each slice would carry a different likelihood of income shortfall and be given a tranche-specific credit rating (more fees!), which would appeal to a broad pool of investors. Add credit enhancement by the monolines (Ambac, MBIA, etc.) and credit protection insurance by the likes of AIG and you’ve got the ideal asset class for the risk-averse, yet yield-hungry, institutional investor.
This was a vast money machine. Wall Street went at it with a vengeance and the fees were coming in by the truckloads. Even some of our venerable Canadian banks got into the game, albeit with much more restraint than their American and European counterparts. In the boom years of 2005 and 2006, more than half of all the mortgage-backed CDOs coming off the pipeline rested on subprime or second-lien mortgages. "
We were in 2006 and then, everything was peachy in the stock and real-estate market. Despite this, many economists and financial analyst were worried about those new instruments. The reason being that the real risks of those investments had been "removed" from the investments themselves and pushed to others. The prudence incentive now removed, banks are then more than willing to lend whereas they wouldn't have been before.
I will let you read the full article by Mr. Gagnon:
I fully agree with him that although Freddie Mac and Fannie Mae had their responsibilities in this debacle, they are mostly scapegoats in identifying the true underlying problem; yes the governments in place (both Democrats and Republicans) made access to property far too easy (and therefore, risky in slowdowns)... Sure, the feds could have been less aggressive in setting their target rates. However, while these created the pre-conditions for the storm, something needed to be in place to short-circuit the self-regulating market mechanisms for so long. It is my belief that removing the prudence incentive from the people who should have been prudent (i.e. the bankers) and instead, giving them the opposite incentive (the more miscalculated risks they took, the more rewards they got), it elevated the economic boiling point and made the consequences more dire.
Would increased regulation help? I don't believe so. The question is; regulate what? These new schemes were but one set of clever ways to increase short term profits; legislating to prevent those could prevent further occurrences of the same schemes, but would it be efficient? I believe that in that specific case, the lesson has been learnt. And, in the future, there will be newer schemes invented that legislators cannot even begin to imagine. Are they going to preemptively legislate on potential dangers and market-failures? That would be highly inefficient.
Doesn't it all really boil down to, as Mr. Gagnon suggest, going back to basics of common sense and discipline? i.e. there's no such thing as a free lunch and it it looks too good to be true (i.e. all the benefits, none of the risks), it probably is?
Any good manager, at whatever level he or she operates, should ask himself; what are the incentives? What are they rewarding? And is where are the risks?
The failure to answer those questions in a time when it seemed than anyone could just go out and print money was, I believe, the core of the problem. Everything else was peripheral. Which will make both the anti-market pundits (predicting the end of the capitalist system) and libertarians (predicting a huge collapse of the dollar, and hyper-inflation) wrong when the markets do recover at the end of 2009 or through 2010.
I also believe that the market is not a theoretical abstraction; it is a real, living, evolving process and, since it involves transactions between sentient beings, it also inherits their learning abilities and their memories. Therefore, by the simple fact that the 2008 crisis happened, the market is now a different beast than what it was a year ago. Regulations could help make us feel better but would do little to prevent future crisis.