The mortgage meltdown and the oil disaster in the Gulf of Mexico have something in common: risk layering.

It’s a self-explanatory concept: When you pile risk on top of risk, that’s risk layering. Driving drunk is a risk. Speeding is a risk. Running red lights is a risk. Driving without a seat belt is a risk. Do some or all of those in combination, and the risk skyrockets.

My local newspaper carried a New York Times article yesterday that recounted the risk layering on the Deepwater Horizon. It was drilling in water a mile deep; more than 98 percent of rigs in the gulf are drilling in water that’s 1,000 feet deep or less. The Deepwater Horizon project got an exemption from a rigorous environmental review, it used risky pipes and casings that deviated from BP’s design and safety policies, it tested the blowout preventer at a lower pressure than was federally required, and the testing of the blowout preventer was delayed.

Risk was piled upon risk upon risk. Regulators condoned the risk layering and deferred to the private-sector geniuses who ultimately set the disaster in motion. Something similar happened in the mortgage business from 2002 to 2007.

With mortgages, it’s risky to lend to borrowers who:

  • Are encouraged to lie about their incomes.
  • Don’t make down payments.
  • Pay only interest and not principal.
  • Have trouble paying bills and thus have low credit scores.
  • Naively trust brokers and loan officers.
  • Borrow more than their houses are worth.
  • Do serial cash-out refinances to buy cars and boats and vacations.

Lenders layered the above risks with abandon. On top of that, risky loans were securitized, giving each party an incentive to pass problem loans on to the next guy.

Anyone could foresee the problems of risk layering. It was one of the most talked-about subjects at a daylong hearing about the mortgage industry that the Federal Trade Commission held in May 2006.

One of the speakers at the FTC hearing was Robert McKew, who was then senior vice president and general counsel for the American Financial Services Association.

Speaking nine months before the beginning of the subprime meltdown, McKew said: “I think as we sit here today, that the mortgage industry, the mortgage lending markets are probably in the best shape insofar as the government regulators, the industry participants, including the secondary market, and consumers basically all have their interests in alignment.”

That mixture of optimism and incoherence is revealing, eh?

McKew added: “The emergence of the secondary market over the past 10, 15, 20 years is actually probably a more real-time implicit regulator of the industry as far as making sure that the right things are happening. If loans are being designed that are … inevitably going to fail or obviously are not going to have a good survivability rate, there will be no buyers for those loans in the secondary market. The secondary market acts as an effective regulator in addition to government regulation.”

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