Banks May Have Been Shady, but Investors Were Stupid

A lot of blame has been thrown around for allowing the housing bubble to grow too large. A common target of criticism is the Wall Street banks. They packaged and sold mortgages that they probably raised their eyebrows at before shrugging as they sold them to investors. This weekend, Gretchen Morgenson from the New York Times takes these firms to task for this practice. But her analysis triggers another question: why did investors allow them to do so?

In her column, Morgenson explains that some banks saw that credit quality was deteriorating, but did nothing. In fact, they kept selling bonds to investors at the same prices they had in the past -- even though the banks knew better:

When due-diligence reports turned up large numbers of defective loans -- known as exceptions -- the banks used this information to negotiate a lower price on the mortgages they bought from the original lenders.

So, instead of paying 99 cents on the dollar for the problem loans, the firm would force the lender to accept 97 cents or perhaps less. But the firm would still sell the mortgage pool to investors at 102 cents or higher, as was typical on high-quality loan pools.

And therein lies the disconnect. If Wall Street banks determined that mortgage quality was getting worse, why didn't investors?

There are two possibilities here: fraud or stupidity. If banks intentionally sold garbage to investors and hid the securities' true characteristics, then that's fraud. But considering how few successful cases, or even accusations, of such wrongdoing against investment banks we've seen over the past few years, this cause was likely uncommon -- and almost certainly not widespread.

That leaves stupidity. Why did investors accept these securities without doing their own due diligence, or demanding that the bank provide its detailed results? One reason was because the rating agencies had already blessed the bonds. But still, investors should have ultimate responsibility for the securities they purchase.

I recently spoke with a former bank regulator about the problems that arose with securitization. I asked him why investors didn't do more to verify what the bonds they were purchasing were worth. He responded that this was precisely the problem that surprised regulators. They expected investors to be a check on the market. If investors had worried more about the credit quality of the mortgages that the bonds they purchased were based on, then the investment banks wouldn't have gotten away with the shenanigans Morgenson talks about above. And if the banks didn't demand more of these loans from mortgage companies, then fewer new mortgages would have been originated. Of course, then the bubble wouldn't have grown nearly so large, and the crisis would have been far less severe.

So while it certainly does sound shady to hear about investment banks selling bonds based on assets they knew were getting worse, investors never should have allowed them to do so. Only they had the power to say "no" to junk securities. Why didn't they?

Economics relies on a very basic criterion that investors act rationally. Yet, it's irrational to buy something you don't understand or don't know much about. As soon as the market stops thinking clearly, bad things happen. This is exactly what we saw in the financial crisis, but how do regulators force investors to think if they aren't already inclined to do so?