Bad Credit Mortgage Mess Shaped by “Moral Hazard”

Today’s subprime meltdown - and tomorrow’s bigger Alt-A mortgage debacle - will bring out a lot of politicians who will demand that something be done to protect consumers from dangerous loans.

However, it’s going to be hard to protect consumers without bailing out the mortgage lenders and investors who were behind those bad loan decisions. That’s where moral hazard comes in.

Moral hazard is an economic and insurance term that describes how people behave recklessly when they’re insured or protected in some way. If you sell flood insurance, people will build on flood plains. If you make airbags and anti-lock brakes standard in all cars, people will drive faster and tailgate more closely. If you introduce fat-free cookies (fat-free, but still loaded with calories), people will eat more cookies than before, and get just as fat.

All examples of moral hazard.

Passing the risk
In the last four years or so, home mortgage standards became lax because each link in the mortgage chain collected profits while believing it was passing on risk to the next link in the chain. Mortgage brokers weren’t lending their own money, so they were pushing risks onto the lenders. Lenders sold mortgages soon after underwriting them, pushing the risk onto investors.

Investment banks bought the mortgages and chopped up mortgage-backed securities into slices, with some slices being less risky and other slices being more risky. Investors bought securities and hedged against the risk of default and prepayment, pushing those risks further along.

All of these businesses accepted profits and tried to leave the next guy vulnerable to risk. Participants thought they were insulated from the negative consequences of bad decisions. That’s an example of moral hazard.

Government help as bailout
Here’s another example of moral hazard: Using government money to help homeowners who are stuck in unsuitable loans and can’t afford their house payments. If not done carefully, this type of aid would subsidize lending institutions that made poor choices. It would bail out the investors who bought risky loans and now don’t want to suffer the consequences of losing their bets.

As for the borrowers who lose their homes in foreclosure: Let this be a cautionary tale. Read your home loan documents. Ask questions. If you don’t understand, hire a lawyer or a certified public accountant to give advice.

Few people hire lawyers or CPAs to review their loan documents now. But 40 years ago, few people wore seatbelts. People have wised up since then.

SOURCE: Bankrate.com