In the old days, when my father was first involved in the mortgage industry (in his case, representing a S&L as an attorney and sitting on its board of directors), mortgage lenders, like Savings and Loans, loaned money for mortgages, which they then kept and serviced until paid off. Later, the selling, holding, and servicing of loans were all split up into separate functions where different parties specialized. The mortgages were packaged and sold in large batches or bundles. The S&Ls pretty much found themselves in the mortgage selling end of the business. And when they found that they could grow much more quickly this way, a lot of them got in trouble and collapsed.
This newest financial scandal is a result of even more sophistication in the mortgage market. Instead of just packaging mortgages into bundles to be sold as securities, the risks in the bundles (the tranches) were split up too, with some of the tranches for a bundle being low risk and low return, while others are high risk and high return.
Part of the problem is that high risk/high return tranches are being bought by parties that shouldn't, such as pension funds trying to make up for previous losses (see "Taxpayers should be afraid, really afraid" below). The other side of the equation is that there are a lot of people who have borrowed to buy overpriced houses (due to the increased demand caused by this whole scheme) using gimmick mortgages, now are rapidly finding themselves over their heads. And, thus, we can expect the foreclosures to continue, if not increase.
Which gets us to part of the flaw in the whole scheme.
And therein lies the problem: an incentive structure that encourages originators to write risky loans, collect the big fees and let someone else suffer the consequences.In other words, since the originators no longer have to either hold the loans or service them, their incentive is to sell them, and as the market got more competitive for higher quality borrowers, the originators became ever more ingenious, inventing every more fanciful ways to get people into mortgages.
What we have here is a failure of common sense. With occasional exceptions, bankers shouldn't make -- or be allowed to make -- mortgage loans that require no money down and no documentation of income to people who won't be able to afford the monthly payments if interest rates rise, house prices fall or the roof springs a leak. It's not a whole lot more complicated than that.