I worked in equity research for several Wall St firms in the 90s and earlier this decade (still do on contract, so I probably shouldn't name names, but big names, I assure you). I wasn't deep in the bowels, exactly, but I wasn't in the executive suite, either. Anybody who now says "gee, we didn't see it coming" is just full of it. Me and my colleagues saw it as far back as 2003. We didn't see the exact contours of the crack-up, of course, and being in research we didn't have first-hand knowledge of either the lending or credit derivatives markets. Nevertheless, we saw even then that the subprime/refi freight train and the ABS freight train were headed right for each other. And if us mid-level guys in research understood what was what (in a Rosencranz and Guildernstern fashion), you better believe the suits did too (we were all suits, but you know what I mean).
That the guys at the top knew what was happening and did nothing doesn't necessarily mean they're a bunch of crooks--the incentives were what they were, and there was absolutely no upside for any individual (person or institution) to do the right thing unilaterally. Your classic collective action problem. Basically I think they just had their fingers crossed, hoping their asses would be near a chair when the music stopped. I attribute my clarity at the time largely to the fact that being in research, my bonus was a fraction of my salary rather than a multiple, so my livelihood didn't depend on me not seeing what was in front of my face.
Anybody still confused about what's going on should go to subprimeprimer.com (mildly NSFW).
Anyuser, your policy recommendations are spot-on, although there's going to be a belling-the-cat problem. It's the separation of risk from reward that got us into this mess. Another way to say it is if you're going to look, walk, and quack like a bank or insurer, you're damn well going to have capital and reserve requirements. The only thing I would add is that SIVs and other balance sheet shenanigans have got to go.
Originally Posted by Anyuser
A fix would be to force, by regulation, the mortgage originator to hold the first piece of the mortgage for its own account, and to comply with margin requirements for any purchaser of the mortgage. This would effectively prohibit banks from making dumb loans. Issuers of mortgage securities should also hold the first piece for their own account (this is often the case now, not by regulation, but because nobody would buy the piece of shit). Sellers of credit default swaps should have balance sheet requirements, should mark to market continuously, and comply with margin requirements when the obligations they're insuring go pear-shaped. Had these requirements been in place 3-4 years ago, we wouldn't have the problems we have now. In other words, the borrowers defaulting now never would have gotten the loans in the first place.