"We don't want to be associated with such a loser," explained a committee member.
Greenspan described his theory in a speech before the crisis. "If you lend people money that they can't possibly repay, just bundle that loan with a million others, then sell the bundle in small bits ("tranches") to someone else.
"Since no single loan is a significant threat to the entire bundle," he said, "The whole bundle is safe."
"In addition, there is no need to regulate this activity. The only people who know the meaning of the word "tranche" are highly sophisticated investors, so why have a regulator check to see whether there's any real basis to the financial instrument? Besides, purchasers will just bundle their scraps with a million other scraps (using the "Hefty Tranche Bag"), and sell tranches of THAT to even bigger fools. Thus there is no significant risk to anyone at all!"
EXAMPLE: Bob has no job or assets. He borrows $500,000 from Crazy Eddie's Nonbank Mortgagelending Co to buy a two-bedroom home, using an Adjustable Rate Mortgage (ARM) at 0% interest for the first 5 years and market rate plus 2% thereafter. Crazy Eddie expects to get five years of payments from Bob. When the ARM adjusts, there's a 95% chance Bob will default. While the actual math is more complicated, in general the expected loss to Crazy Eddie is roughly 95% of $500,000 or $475,000. Therefore, Crazy Eddie divides the mortgage into 100,000 tranches, each of which risks losing only $4.75. Compared to the original loan, this is practically zero, so with the help of a friendly rating company, Crazy Eddie sold all of these tranches as Triple-A rated securities. Crazy Eddie's competitors had to do the same thing, or go out of business. For more details (including actual cases), see The Giant Pool of Money.
"Regulation of securitized mortgages," he concluded, "Will only interfere with the process. Private lenders, unconnected to any bank or other lightly regulated institution, will flood the market if left unchecked, and the result will be continually increasing financial activity with no need for a physical reality check at all. It's like magic!"
"A few of us thought this was a great idea," said one committee member, speaking on condition of anonymity, "And thus invested heavily in the market. Now we're melting down past awards for the bullion. Or maybe we can eBay something. We need the money!"
The Nobel Prize Committee in Physics issued a statement: "We have previously discussed prize nominees in the field of perpetual motion machines. They were always good for a laugh. Who knew that economists would take it seriously?"