The author will offer a myriad of explanations for the crisis: easy money; flawed models; a lack of regulation or regulators willing to perform their designated function; more risk-taking on the part of housing finance agencies Fannie Mae and Freddie Mac, which bought and guaranteed lower-quality mortgages in order to stay in the game; conflict of interest on the part of credit rating companies; a misplaced belief that housing prices never fall on a nationwide basis; lax lending standards; too much leverage on the part of financial institutions; too little oversight of those same banks; a lack of transparency on securitized loans...the list goes on.

There is, however, something basic underlying all the excesses. And that’s the issue of misplaced incentives.

A mortgage lender had little incentive to perform adequate due diligence on a borrower when the loan was bundled and ushered out the door almost as soon as it was booked. The lender pocketed his fee, and that was pretty much the end of his responsibility. It didn’t matter if the homeowner couldn’t afford his home, couldn’t afford to make a down payment or meet the monthly interest. It was someone else’s responsibility.

Oh sure, there was a small incentive to ensure the borrower could at least make the first few payments. Early payment default—within the first 90 days—means the originator is on the hook. In a booming housing market with low teaser rates for unqualified buyers, lenders didn’t have too much to worry about in the early months. And after that, why, refinancing was the cure for whatever ailed the homebuyer.

The lender also had some “representation and warranty exposure," says Josh Rosner, a managing partner at Graham Fisher and Co. in New York. “If the loan was defective or misrepresented, the lender was obligated to buy it back from the pool."

What exactly was the lender representing and warrantying? It wasn’t necessarily a homebuyer’s income or assets or ability to meet timely payment of principle and interest. In some cases, “the guarantee was limited to a few basic facts and didn’t address the borrower’s ability to repay," says Andy Laperriere, a managing director at the International Strategy and Investment Group Inc. in Washington. “It was not an incentive to make a responsible loan."

What’s more, the underwriting guidelines for the loans purchased and packaged were so watered down as to be almost meaningless, according to people who review structured loans for clients. Those guidelines, included in the offering prospectus of collateralized debt obligations, tend to leave lots of room for “exceptions" that could be “material," resulting in greater-than-anticipated delinquency rates.

It wasn’t the securitization process per se that got us into this mess. While the market for securitized loans is temporarily out of service, it doesn’t have to be outlawed, along with short-selling of stocks and speculative buying of commodities. The problem lies with the loans that were being securitized. The lender had very little skin in the game. The appreciation in home prices in the first five or six years of this decade papered over a lot of bad lending decisions. A non-performing loan is no problem when the underlying collateral (the house) is performing so spectacularly.

When house prices stopped rising, then turned south with a vengeance last year, mortgage aggregators, securitizers and servicers would have been happy to put delinquent or defective loans back to originators. By that time, “subprime lenders had gone out of business, and there was no one to buy them back," Rosner says.

Like subprime lending, mortgage modification “works in an appreciating market but is a bad idea in a falling home-price environment," he says.

The recidivism rate is high among defaulted borrowers who get modified loans. Even in the rising home-price environment of 2002-2003, the federal housing administration “had a 25% default rate on modified loans within two years," Rosner says. Mortgage modification is among the government’s “fixes" for the current crisis, very few of which champion individual responsibility. That’s too bad, because the abrogation of responsibility on the part of the lender lies at the root of this crisis. Unless lenders are held accountable for their actions and liable for any fraud, the other solutions aren’t worth the paper they’re printed on.

The days of the community banker who knows his client—knows the value of his house and the cash flow of his business—may be over. On some level, we need to extrapolate those standards to today’s globalized world so that the Panic of 2008 remains a true, once-in-a-century event.

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