fcoulter, I think the truth lies somewhere between my posting and your response. You say unemployment was low at the time of the mortgage crisis. I'm in Michigan, so don't talk to me about low unemployment. The Big Three car companies have been doing mass firings since the early eighties, when Reagan taught them it was a fine thing to do. Mass firings (or, as the news media euphemistically call them, "lay-offs") have ripple effects, throughout the my state and the country, and even the world. The car companies and the other mass firing companies slowly and gradually pushed the economy to a tipping point. The mortgage crisis signaled that that point had been passed. Let's face it, unemployment and mortgage defaults are in an elaborate feedback loop. In a loop like this, cause and effect become smeared together. It's all interconnected. I think you understand. So in a way, we're both right.
In response to "amarquis" I would then conclude that the rating agencies had no business issuing any rating at all. But of course if they did that they would loose out on those lucrative remunerations for their "services". The rating agencies are as much at fault as the thieves that came up with the scheme in the first place. The government shares in the blame for allowing Paulson to allow banks to do this and then bringing him into government to "solve" the problem that he created. The blame can be spread far and wide, but the rating agencies are thought to be there to provide investors of all calibers a reasonably accurate estimate of future value of various investment instruments. Again, if they lack the knowledge to provide that reasonably accurate estimate, they are guilty of accepting "kickbacks" for fabricating ratings according to their clients wishes.
"The ratings institutions, which people depended on, didn't look under the sheets and went solely on the risk of other instruments by the same institution."
This isn't quite true. The ratings institutions didn't just gloss over the job of rating these financial instruments, the securities were very hard to rate because small changes in assumptions changed the outcomes of their models in violent ways.
When a bunch of mortgages are packaged as a security, not all shares are created equal. They are divided into tranches, with lower tranches being the first to absorb losses. So, if mortgages start to default, the junior tranche owners absorb all the losses until they have nothing left, then the middle or mezzanine tranches start losing. Only once they are all wiped out do owners of the senior tranches start to suffer.
Consider the math here: If each mortgage in a package of, say, 10,000 has a 5% chance of default and the defaults are totally uncorrelated, what is the chance that most of them will default and start hurting the top tranche? Practically nothing. What if they are perfectly correlated? In that case they all fail or all succeed, and the senior tranche has a 5% chance of loss, just like the other tranches.
The fact that the one assumption, the level of correlation, has such a dominating effect makes these securities very hard to rate. Banks took advantage of this by packaging crappy mortgages in such a way that the senior tranches would get very good ratings. Because, hey, what's the chance of MOST of these crappy loans failing? (Answer: Higher than everybody thought)