Why Subprime Scams ?
Worse than a crime a mistake.

Reading the news I learn about the sub prime mortgage loan melt down. Very briefly, people were loaned money to buy houses under conditions such that default and foreclosure was very likely. Now there is a huge increase in foreclosures. Futhermore the lending banks are going under. People will gamble to get a house, but why did the banks do such a stupid thing ?

The general line in the left blogosphere is that it is all Greenspan's fault. Pumping the system full of liquidity to end the 2001 recession he put banks in a position that "they would loan to their household pets" (I forget who I am quoting sorry). This is appealing, because we never liked having to praise a fan of Ayn Rand. I have another thought.

Bankers wanted to foreclose, because they assumed house prices would go up forever.

Banks are not allowed to invest in real estate for the very excellent reason that it tanks in value exactly when debtors default and banks have to unload foreclosed real estate. A bank investing in real estate makes OK returns most of the time and goes bankrupt when the local real estate market collapses. Thus the FDIC or FSLIC takes a hit if banks over invest in real estate. Thus it is forbidden.

However, nothing prevented banks from making loans with a high chance of foreclosure. If 10% of debtors default, the loan portfolio is 10% real estate. Thus crazy loans can serve as a means to evade the ban on local real estate investments. If the bankers were irrationally exuberant about the local real estate market, just like their foolish borrowers, they would be enthusiastic about a chance to get their hands on real estate in the future in exchange for cash now.

Sub prime loans allow borrowers and banks to bet on local real estate, splitting the winnings depending on whether the borrower gets lucky and manages to service the loan, and stiffing the FDIC or FSLIC with the losses if the market collapses.

Makes sense to me.

The scam would be perfect if proceeds from foreclosure were securitised as are interest payments and principal repayments. A diversified portfolio of foreclosure bonds would have moderate risk and a claim on a flow of cash from the federal treasury.