So what went wrong?  Under the current system, these loans were sold to the big Wall Street investment firms who repackaged them as collateralized mortgage obligations (CMO’s), Mortgage Backed Securities (MBS’s) and other similar acronyms.  These instruments were then sent to the ratings agencies for their blessing and more importantly a letter rating.  Many of these structured finance deals receive AAA ratings—the highest ratings available meaning that in theory, these instruments were least likely to Default.  How does one create a ‘triple A’ or AAA rated financial instrument out of sub-prime mortgages?  Herein lies the magic.  These Asset Backed Securities (ABS) are made up of different tranches or slices, each carrying a different risk and reward level. The first dollar of principle and interest is applied to the securities with the highest rating, and the first dollar of loss is applied to the tranche with the lowest ratings. The lower slices are designed to provide a security blanket that in theory protects the higher-rated securities.  The investment banks that package or ‘structure’ these securities in order to earn fat fees when they sell them to investors are the same entities that pay the ratings agencies to rate these instruments.  Clearly the possibility for conflict of interest is present.  If investors and not the investment banks that stand to rake in millions in fees were to pay for the rating, the potential for this conflict of interest would be negated. Furthermore, the investment banks have a vested interest in convincing the ratings agencies of the credit worthiness of these securities.

So we’ve already pointed fingers at homeowners, some greedy, many more I suspect, naïve or uninformed, real estate agents—one out of more than 60 in my experience was a gem, mortgage brokers & bankers, banks, Wall Street and ratings agencies so who’s left? The Federal Reserve and the Government of course.

The Fed as its known is responsible of the country’s monetary policy and for supervision and regulation of banks.  This is the definition of the Fed’s roles in their own words:

Monetary Policy

The Fed is best known for its role in making and carrying out the country’s monetary policy—that is, for influencing money and credit conditions in the economy in order to promote the goals of high employment, sustainable growth, and stable prices.

The long-term goal of the Fed’s monetary policy is to ensure that money and credit grow sufficiently to encourage non-inflationary economic expansion.

The Fed cannot guarantee that our economy will grow at a healthy pace, or that everyone will have a job. The attainment of these goals depends on the decisions of millions of people around the country. Decisions regarding how much to spend and how much to save, how much to invest in acquiring skills and education, how much to spend on new plant and equipment, or how many hours a week to work may be some of them.

What the Fed can do, is create an environment that is conducive to healthy economic growth. It does so by pursuing a goal of price stability—that is, by trying to prevent inflation from becoming a problem.

A stable level of prices is most conducive to maximum sustained output and employment. Also, stable prices encourage saving and, indirectly, capital formation because it prevents the erosion of asset values by unanticipated inflation.

Inflation causes many distortions in the market. Inflation:

• hurts people with fixed income—when prices rise consumers cannot buy as much as they could previously
• discourages savings
• reduces economic growth because the economy needs a certain level of savings to finance investments that boost economic growth
• makes it harder for businesses to plan—it is difficult to decide how much to produce, because businesses can’t predict the demand for their product at the higher prices they will have to charge in order to cover their costs

Bank Regulation & Supervision

The Fed is one of the several Government agencies that share responsibility for ensuring the safety and soundness of our banking system. The Fed has primary responsibility for supervising bank holding companies, financial holding companies, state-chartered banks that are members of the Federal Reserve System, and the Edge Act and agreement corporations, through which U.S. banking organizations operate abroad.

The Fed and other agencies share the responsibility of overseeing the operation of foreign banking organizations in the United States. To insure that the banking system remains competitive and operates in the public interest, the Fed considers applications by banks for mergers or to open new branches.

The passage of the Gramm-Leach-Bliley (GLB) Act in November 1999, was the culmination of a multi-decade effort to eliminate many of the restrictions on the activities of banking organizations.

Some of the main provisions of the GLB are:

• Repeals the existing limitations on the ability of banks to affiliate with securities and insurance firms

• Creates a new organizational form that allows banking organizations to carry new powers. This new entity called a "financial holding company," (FHC) and its non-banking subsidiaries are allowed to engage in financial activities such as insurance and securities underwriting

The Fed’s enlarged role as an umbrella supervisor of FHCs is similar to its role in supervising bank holding companies. The Federal Reserve Banks will supervise and regulate the FHCs while each affiliate is still overseen by its traditional functional regulator.

The Fed has to delineate the financial relationship between a bank and other FHC affiliates. Its primary goal is to establish barriers protecting depository institutions from the problems of a failing affiliate. To do this efficiently the Fed has to ensure increased communication, cooperation, and coordination with the many supervisors of the more diversified FHCs.

The Fed has access to data on risks across the entire organization, as well as information on the firm's management of those risks. Regulators will be in a position to evaluate and presumably act on risks that threaten the safety and soundness of the insured banks.