This is how I understand the fiasco, and I welcome anyone to correct me. To me, it’s obvious that the banking industry does need regulation for derivative markets like securities and CDOs. The biggest opponent to regulation in the late 90s was Greenspan, and he admitted the greed of the industry did need regulation and he changed his mind - testified more regulation was needed. One thing that Conservatives seem to understand better than Libertarians (like me) and Liberals is human nature and greed. However, their good judgment seems to only apply to poor people and not rich people.
• JPM creates the security product to help offset risk. Good idea.
• Mortgage companies realize they can sell their risk using this new JPM idea.
• This makes sub-prime loans seemingly more attractive to investors because mortgage banks can sell the risk to anyone who wants to buy it (AIG and foreign unregulated banks).
• So now – they can loan money to an unemployed person at 40% interest for more than the home is worth. No normal person would take that risk, but they can sell the risk and group loans in “tranches” to make it look like a good investment.
• This makes the bankers really want to loan as much money as possible – even to high risk borrowers. More houses are getting sold because more loans are made.
• This means the price of housing shoots up creating a bubble.
• The risk is still there, it’s just hidden. Eventually, the toxic loans default. Housing sector dives causing even more loan defaults.
• Bank heads to the securities providers. "Pay me because you said you would take the risk"
• Security providers say – "screw you, I was just looking to make a quick buck. I’m out."
• Bank says to investors – "oops – we don’t really have that money because our risk taker doesn’t have the money" – the risk taker didn’t need to have the money because they weren’t regulated like normal insurance industries are regulated.
• Banks hold hands out to the American tax payer to pay for the mistake.
In short, it seems like the securities brokers need to be regulated like insurance companies are. It seems all derivatives markets should be highly regulated. I don't see how breaking up the large banks would have stopped this from happening, but regulation of the derivatives market (credit securities, swaps, and CDOs) would have.
Let me know where I'm wrong. I'm just learning about this. Goldman Sachs and AIG look like the real evil American parts of this deal. I'm sure there are others I don't even know.
Isn't the heart of the problem banks selling the risk to separate companies (often owned by the same bank or foreign banks) who could then default on that risk? Investors – even smart ones, were either too greedy or too naïve to see this happening.
