The other shoe
The bailout of the US financial sector through the Troubled Assets Recovery Program (TARP) looks to have been fairly successful on its own terms – the banks have become profitable again and the final estimated loss to the government is relatively small. That doesn’t change the fact that the government took on huge risks for negative returns, without any reason to expect that the future behavior of the banks will change.
But all of that was based on assumptions of an orderly resolution of the mortgage crisis. Those assumptions now look very dubious, as the legal consequences of the practices of the financial sector during the bubble, ranging from sloppiness to outright fraud, manifest themselves.
First, foreclosure proceedings have ground to a halt as it has proved impossible to produce proper documentation. Even more striking is the latest scandal discovered by Felix Salmon (hat tip Brad DeLong).
It turns out that the Wall Street investment banks did perform due diligence on the mortgages they were being sold for repackaging into CDOs and other derivatives, and found that as many as half of those in typical samples were defective. Instead of killing the deal, they lowered the price they paid to the originating banks, and went ahead to sell the securities to investors, without telling them how bad the mortgages were.
Salmon gives chapter and verse on this and concludes “It’s going to be a very long time, I think, before the banking system is going to be free and clear of the nightmare it created during the boom.”