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Just as the United States stood behind its banks, in part, to avoid losing the confidence of foreign investors, Abu Dhabi might have to do the same.

That had to be what Citigroup, with its firsthand expertise with bailouts, must have been thinking when it lent $8 billion to Dubai last year. Oh, and here’s an interesting fact: Citigroup made the loan to Dubai on Dec. 14, 2008. Take a look at the calendar — that’s after it received tens of billions in TARP funds.

If the reason that "banks" were leveraging up in the first place is, as Posner maintains, that they cared only about profits and ignored possible losses (because their executives and employees were compensated for short-term profits, regardless of the long-term risks), then banks should have bought AA securities every time: The AAs paid more than the AAAs--precisely because they were riskier.

But in fact, only 19 percent of the mortgage-backed securities held by the banks were rated AA or lower. Eighty-one percent were rated AAA, yielding less short-term profit because they carried less risk. This one fact may refute the executive-compensation theory all by itself.

regulators outsourced bank capital regulation to the credit rating agencies. This set off a frenzy of innovations designed to manufacture AA and AAA rated securities out of junk mortgage loans.

The net result was that bank capital regulations, which were supposed to promote safety and soundness, did the opposite. There was excessive leverage, because the banks were able to hold the same risk with less and less capital needed to comply with regulations.

Barofsky offered criticism in a separate quarterly report
of Treasury’s implementation of TARP, saying the department has
“repeatedly failed to adopt recommendations” needed to provide
transparency and fulfill the administration’s goal to implement
TARP “with the highest degree of accountability.”

As a result, taxpayers don’t know how TARP recipients are
using the money or the value of the investments, he said in the
report.

Understanding the causes of the foreclosure explosion is required if we wish to avoid a replay of recent painful events. The suggestions being put forward by the administration and most media outlets -- more stringent regulation of subprime lenders -- would not have prevented the mortgage meltdown regardless of their merit otherwise.

Rather, stronger underwriting standards are needed -- especially a requirement for relatively high down payments. If substantial down payments had been required, the housing price bubble would certainly have been smaller, if it occurred at all, and the incidence of negative equity would have been much smaller even as home prices fell. A further beneficial regulation would be a strengthening, or at least clarifying at a national level, of the recourse that mortgage lenders have if a borrower defaults. Many defaults could be mitigated if homeowners with financial resources know they can't just walk away.

Soon after the capital accords were rolled out, banks began to come up with ways to “game” the system. For mortgages, the two most important techniques were securitizing mortgages and creating off-balance-sheet vehicles. Securitization allowed banks to get large portions of their mortgage portfolios rated AAA, and these AAA ratings in turn lowered capital requirements, particularly after a revision to the capital requirements that was formalized on Jan. 1, 2002. The off-balance-sheet entities were an even bigger scam, because generally-accepted accounting principles (which the regulators copied) allowed the banks not to count the mortgage securities in these entities as assets at all.

All of this was done right under the nose of the regulators.