James Hamilton writes,

I believe there was an unfortunate interaction between financial innovations and lack of regulatory oversight, which allowed the construction of new financial instruments with essentially any risk-reward profile desired and the ability to leverage one’s way into an arbitrarily large position in such an instrument. The underlying instrument of choice was a security with a high probability of doing slightly better than the market and a small probability of a big loss.

Hence, subprime loans. Hence, selling credit default swaps.

In my previous post, I mentioned Adam Michaelson’s book on Countrywide. He also argues that the incentives were to push for short-term profits and to ignore long-term risks. He describes a meeting where the option-ARM (most people’s candidate for Most Dangerous Mortgage Product Ever) was introduced. I’m not sure that Countrywide was the first to market with it–their version may have been a “me, too” offering. Jim Hamilton’s question boils down to: what would have changed the incentives at that meeting?

As I have written before, I think that we ought to make it a crime to endanger a financial institution that has government backing. Countrywide owned a bank, which means it had government backing. If the executives running Countrywide had faced the threat of prison, my guess is that the tone of the meeting where folks were proposing the option-ARM would have been a teeny bit different. My guess is that Michaelson and other doubters of the proposal would have been listened to a lot more carefully and been given a lot more encouragement. The proponents of the idea would have had to justify to Angelo Mozilo why they should do something that could land him in prison.

Mozilo, with his swarthy looks, sharp suits, and proud demeanor, could play the part of a crime syndicate figure on a cop show. But as far as I know, he was not that sinister. In fact, he was a really good CEO, who, like many other good CEO’s, decided to ignore the possibility that the housing bubble could pop. They needed different incentives.