The mortgage backed security (MBS) was, at the time of its conception, a brilliant way to create a new asset class while extending more credit for home buying. The originate-to-distribute model means that banks issue MBS securities with the intent to distribute them to investors, as opposed to taking on the risk themselves. Distributing MBS securities takes the risk away from the banks and spreads it over a group of investors. The interest payments represent the return on the investment, while credit ratings and default probability represent risk. There was, however, a moral hazard in this design that few gave any thought to. The originate-to-distribute model provided no incentive for banks to perform due diligence on the loans they were creating. As soon the loans were created, they were packaged to investors so that the bank was no longer exposed to the risk associated with foreclosure.

Also, instead of receiving value from good loans in the form of on time payments and low foreclosure rates, banks benefited instead from creating more loans than their competitors. The system became much like a commissioned sales position, and quantity overcame quality as the main driver of profit. Big loans were pushed by polished salesmen onto people that understood very little about the underlying details of the mortgages. This focus on volume created a system where it was most profitable to give the biggest loans possible to each customer, regardless of their ability to pay it back.

In addition, because of the extra party involved in the MBS securitization process, foreclosures suddenly became a legal nightmare. If a bank owns a mortgage and the house is foreclosed, then that house suddenly belongs to the bank. However, with the arrival of global MBS investors, that house now belongs to a pool of diverse investors. It was no longer clear how to proceed with the foreclosure. As a result the overall cost to the economy of foreclosures spiked tremendously. Upon foreclosure, multiple counterparties came into play and the process put more strain on the fragile sinews of the financial system.

These two problems contributed to the declining quality of the MBS pool. How could this have been prevented? There are several ideas to choose from.

First is creating levels of risk exposure so that banks would still have incentive to perform due diligence on loan applications. Banks would be forced to maintain a certain percentage of exposure to the loans they write. Now, an incentive would exist for banks to balance quantity and quality.

Also, the evolution of subordinated tranches may help create more specific risk parameters for the mortgage backed security. Instead of a convoluted bunch of boxes no one can see into, tranches must become transparent and easy to understand. Risk is not a bad thing, but risk that is covered in layers is dangerous indeed.

Credit default swaps must be scrutinized. They are not inherently an evil security, but they allow users to take tremendous bets on assets they do not own, which is basically a legalized form of gambling. The CDS market will have to come under some regulations. The use of clearinghouses may squeeze the profits that banks experience when utilizing these securities, but it will lower the counterparty risk associated with the OTC markets.

Are these the answers? Maybe not. More bold moves may be required. One thing is for certain; without new regulations in place, this will happen again. Capitalism produces winners and losers. The motives of these regs should be to protect malicious asymmetry of information without removing the ability of the markets to efficiently channel funds and drive innovation. The danger of over regulation is certainly present, but the current situation of no regulation has proven to be inadequate. Without taking steps to reestablish the trust that is so crucial to our financial system, investors will continue to lack the confidence to drive a strong recovery.