A commentary from my brother, Doug, who is a former structured finance banker with Credit Suisse and attorney admitted in NY and CA. He now leads a private commercial real estate investment advisory firm. I asked him which candidate best grasps the current challenges, and got this very user-friendly description of how we got where we are…

Neither understands the genesis and progression of the credit crisis, they don’t understand the financial instruments and the structured transactions in which these instruments are being securitized and hedged.  Politicians absurdly believe that they can control and manipulate microeconomic events, such as the nature of the individual credit transactions occurring in the market. They can’t. Macro-level policies which support a flexible regulatory scheme that can identify and monitor systemic risk levels are the best that can be hoped for.

Bankers engineer products to fit the gaps provided in a static regulatory environment maximizing return to the firm – each bank has its own internal risk management policies and enforcers, some better than others (Goldman as compared to Lehman).  The state and federal regulatory bodies back-stop the internal risk management controls and provide discipline at the firm level should it be lacking. They also provide a macro perspective on how the cumulative low-level risk of individual firms can create a systemic problem.  The residential mortgage brokerage and mortgage origination business didn’t have the needed oversight – there is no uniform mortgage brokerage licensing, oversight or continuing education body. This means that mortgage brokers are sometimes little better than used car salesmen.

Unfortunately, all the garbage loans that were brokered should have been checked by the bank originating the loan, but the banks didn’t have the guts to turn borrowers away. For instance, if WaMu said no to a risky borrower, they knew 100% that the business would go next door to CountryWide. Lenders couldn’t live with turning business away because their stock price would suffer as would their compensation. Their risk management strategy was instead of turning away garbage coming in, find a way to get the garbage out after they made the loan. 

Wall St. provided a brilliant way to take these garbage, undocumented, non-creditworthy borrowers and create financial instruments (bonds or CDOs) with variable risk characteristics (tranches) and then insure a senior portion to create an investment-grade rating (like putting a turd in a golden jewelry box).  In short, too much of it was put into the system and borrowers began defaulting, starting the domino effect…

This is where the story really begins, and while a politician may be able to grasp the above it would be next to impossible to try and illustrate the ripple effect through the financial system because its not really a domino effect - a straight-line domino chain is far too simple.  Think about the effect being more like someone tossing a couple handfuls of gravel into a pond all at once – each stone is another issue or problem each with its expanding concentric circle of subsequent effects. Each time one of these circles collides with another adjacent circle, the waterscape changes…