Keeping Lenders Honest

A followup on an earlier discussion: You may recall that one of the provisions of the new financial reform legislation was intended to hold lenders' feet to the fire by making them hang on to 5 percent of the subprime mortgages they had issued. In the past, these lenders had been able to securitize and sell off all of the mortgages they issued, leaving them with little incentive to worry about whether the loans would ever be paid back.

Now, forcing these people to keep 5 percent of their loans doesn't sound like an awful lot. But in his new book The Big Short, Michael Lewis explains why this small step could make a big difference. In the first wave of subprime lending, in the mid-1990s, Lewis notes that the lenders didn't bother to sell off every last mortgage they issued. These lenders almost all failed, Lewis says, because even keeping a small fraction of their loans proved to be toxic.

So perhaps the new law has a good chance of keeping lenders honest, and prevailing upon them to issue mortgages only to people who are likely to repay them.