I could never figure out how banks and securities dealers talked themselves into loaning money to people that common sense would tell you never could repay their obligation. Listening to this episode of This American Life – Giant Pool of Money revealed that it was incremental greed that drove each link in the chain to justify the crazy loans that were extended – a kind of slow boiling of the frog – which gradually upped the ante until the market could no longer sustain it.
A vital oversight often overlooked was that with the Mortgage-Backed Securities that were famous for bundling up poorly graded loans with a few high-performing loans to basically pretty up a pig, the complex risk management tools that were used for analysis failed completely because of the lack of historical data.
Very simply, no one had ever extended credit under such situations before (i.e. NINA loans, No Income, No Asset) so they assumed an overly optimistic rate of default and dealers let the computer models talk them into taking on loans that just didn’t make sense.