In simplest terms, the mortgage lending industry collects deposits to make loans possible.  As mortgage lending has grown increasingly complex, the checks and balances of a simpler time have been lost.  Like the proverbial frog boiled as the water temperature rose, bankers did not perceive the changes in systemic risks.  Like the subjects in Hofstadter’s “Escher, Gödel and Bach”, a strange loop has been formed that could not be predicted from its components.

http://en.wikipedia.org/wiki/G%C3%B6del,_Escher,_Bach

In place of the original triplet of depositor, banker and borrower, today we have no less than 14 actors to consider: borrower, mortgage broker, mortgage product, mortgage broker firm, mortgage lender, guarantor, consolidator, mortgage-backed security, securitized asset, credit default swap, credit rating agency, investment banker, investors, regulators and auditors.

In 1776, Adam Smith provided scientific, philosophical, ethical and political support for free markets of independent buyers and sellers. Academic economists from Alfred Marshall through the Chicago School provided sophisticated theoretical, historical and statistical support for free markets.  Ronald Reagan and Margaret Thatcher consolidated political support for free markets.  NONE of them had a 14 step conga line in mind.

http://www.youtube.com/watch?v=RKtPrOiMj3o

At every step, we have the risks of self-interest creating failure rather than an efficient market with optimal social welfare.

Borrowers have an incentive to lie to mortgage brokers about their income.

Mortgage brokers have an incentive to process as many successful mortgages as possible, coaching borrowers and appraisers.

Mortgage lenders and firms have an incentive to devise mortgage products that are most attractive to borrowers, including no money down, variable interest rates and negative amortization beauties. 

Mortgage broker firms have an incentive to generate volume, without regard to the risks that will be born by the lenders or investors.

Mortgage lenders have an incentive to book as much volume as possible; locking in profit spreads for 30 years.

Fannie Mae and Freddie Mac serve a pivotal role, consolidating and guaranteeing individual loans and collections of loans in support of the American ideal of home ownership.  As quasi-government agencies, they have an incentive to capture congressional support through campaign contributions.

http://www.diffen.com/difference/Fannie_Mae_vs_Freddie_Mac

Mortgage backed securities provide the key gap in the chain of responsibilities.  They allow the mortgage brokers and lenders to transfer liability for mortgage defaults to investors.  Theoretically, these financial instruments greatly increase the sources of funds and through the portfolio effect reduce risks for everyone.

http://en.wikipedia.org/wiki/Mortgage-backed_security

The most sophisticated financial engineering is used to transform a portfolio of mortgages into a new set of securities that separate risks into layers, theoretically allowing some investors to have low risks and returns while others assume moderate and higher risks and returns.  This financial alchemy also increases the pool of potential investors and fine-tunes the risks assumed.

http://en.wikipedia.org/wiki/Securitization

Investors in mortgaged backed securities and their derivatives are not fools.  They understand that risks accompay these innovative instruments and that there are inherent underlying risks.  As sophisticated investors, familiar with derivatives of all flavors, they seek ways to limit their risks.  Credit default swaps were created to provide them with additional security about the risks involved in investing in securitized mortgage based securities.

http://en.wikipedia.org/wiki/Credit_default_swap

Credit default swaps and mortgage-backed securities are evaluated by credit rating agencies.  The growing complexity of financial instruments greatly increased their business volume and relations with investment banks.  They provided overly positive ratings historically.  They were paid by the firms that created the securities.  No one should be surprised by the results.

http://en.wikipedia.org/wiki/Credit_rating_agency

Investment bankers have played a key role in the growth of the securitized mortgage industry. They collect fees as advisors in the creation of products and as advisors to mortgage brokers, mortgage lenders,  guarantors,  consolidators and investors.In their banking role, they have invested directly in these securities, provided funds for others to invest and developed derivatives to allow bets against the securities.  Investment bankers have supported both political parties.

The securitization of mortgages has allowed a wide variety of individuals and firms to invest in these assets, including banks and investment banks as part of their overall portfolios.

Regulators have tried to keep pace with these innovations, but failed.

Auditors have invested their resources complying with the details of the Sarbanes-Oxley legislation, but missed the change in risks in this complex system.

The mortgage world has become very complex in the last 30 years.  The proponents of “financial reform” in both parties need to closely review the reality of a 14 actor system.  There is a trade-off between the benefits of financial innovation and the regulatory costs of financial complexity.  We have clearly crossed the line where the costs of complexity (regulatory and risk) have exceeded the benefits of innovations (funding and reduced risks).