BluefoxToday blog : May 2007

Subprime dilemma and "moral hazard"

That's an intriguing thought. Moral hazard. What is it? It's a term in economics and insurance that explains how people behave carelessly when they are safeguarded or insured in some way. Let's take an example from the real estate business. If companies make flood insurance available, people will feel it's now okay to build homes on flood plains, because they are covered. Otherwise they wouldn't, goes the theory.

It applies to the mortgage business in a logical manner. A few years ago lenders eased on their underwriting standards to make more money. Well, when you do that, the whole process also becomes more risky. We know that most of these home loans were sold rather quickly in bundles to the secondary mortgage market. This is where Fannie Mae and Freddie Mac operate, among other private entities. There they were dutifully reshaped into different securities, each pool bearing its own risk label. With that done, large domestic and international  institutions found them attractively priced and decided to buy them for their portfolios. They promptly hedged these mortgage-backed securities against default or prepayment, passing on the risk ever further down the line.

So, at each sale of a mortgage the seller gets a fee and, more importantly, feels relieved because he's no longer exposed to risk. The new buyer is. It's his paper now. If it goes south, he's in trouble. And so it goes step by step. That's what they say is moral hazard. Interesting?

 

 

_______________________________________________________________________________

Provided by: 

Esko Kiuru
Mortgage, real estate and apartment industry analyst 

www.BluefoxToday.com - syndicated mortgage, housing and property management blog

eskokiuru@gmail.com
My cell: 702-499-1006

Comment balloon 8 commentsEsko Kiuru • May 01 2007 12:12PM
Subprime dilemma and "moral hazard"
share
That's an intriguing thought. Moral hazard What is it? It's a term in economics and insurance that explains how people behave carelessly when they are safeguarded or insured in some way. Let's take an example from the real estate business. If… more