A little while ago, Warren Buffet explained that financial institutions that have bad-looking balance sheets because of the subprime loans and mortgage crisis should deal with the problem on their own, i.e. without the help of taxpayers (see here). This is pretty much what Austrians, especially Mises, have always advocated. When the downturn is on its way, there is nothing the Central Bank or the government can do to speed the recovery up. As Mises famously put it: “There is no means of avoiding [the] consequences of the preceding boom.”
Many of the mortgages the banks securitized in the last five years were bad to begin with. When a bank sells a mortgage to someone who has no outside collateral, at a variable rate, and with no deposit, it cannot be a good thing. The problem is that banks started doing this en masse in the early 2000s. The question is why?
The Economist last week (see here) had an article presenting recent academic works on debt securitization. They explain for instance that “by breaking the link between those who vet borrowers and those who bear the cost when they default, securitization led to the lax lending that both fuelled and felled America’s housing market.” They add: “the incentives to check on the creditworthiness of the borrowers were likely to be the weakest” in the situations where mortgage originators made bad decisions. In other words, “poor screening by mortgage originators intent on selling on loans was a significant factor in the housing boom and bust.” However, the article doesn't say much about the source of these bad incentives.
As Pete and Steve have explained it before, the FED’s easy monetary policy is THE main reason why banks came to face the wrong incentives. When inflation expectations are such that people believe house prices will continue to go up in the foreseeable future, even bad loans go through (and many went). All this was bad risk management and banks are now paying the price. Because securitization is now very complex, the question is whether there is a systemic risk for the whole economy as some have said. Buffet doesn’t seem to think this is the case as long as the natural clean up can take place. It will take some time, but if the government doesn’t interfere, the US economy will clean itself up of all its malinvestments. This sounds very Misesian to me...