Does the fed liquidity process create potential for moral hazard in lending?
Looking back at the 2007-9 mortgage lending crisis, many people point to the culprit being the poorly understood and overly complex mortgage backed securities instruments. But what if it’s not really the instrument to blame but really the moral hazard that these instruments created. More importantly, does the fed and the treasury’s pouring money into the debt markets end up creating the same situation?
For the most part, financial instruments aren’t inherently evil.
Describing what I understand as the mechanisms for what we’re experiencing right now – and I’m going to keep it top level – I’ll start with the Fed and the Treasury adding more liquidity to the market. That means there’s generally more money to lend. The reasons are many, but I believe the core reasons are pretty altruistic.
The theory goes if there’s more money in the system, it will be used to build more wealth through the multiplicative powers of lending. The enhanced liquidity also has a benefit as it convinces others to keep rates low. This forces the more security minded people to move their money into more risky assets to find better return. This movement of funds purportedly spurs on growth.
Another aspect that creates awkward/dangerous situations is lenders really don’t keep mortgages on their books anymore. Instead, they originate the loan, pack it up into other financial instruments and sell them off to others. That means banks don’t really make any money off of interest for the most part. They make it out of origination charges.
The loop back in this system appears to be where the Fed buys up loan instruments. By doing so, they put the aforementioned cash back into the financial system, as we were talking about in the beginning. And yes, some of those instruments purchased are the same sorts made famous in The Big Short.
If this is really the way things are working now, it would appear to me that there’s a very good case for moral hazard issues to develop. Where do you say?
My thinking points to the facilities making loans and the Fed itself.
Since the firms don’t make money from interest on holding the loans anymore, the next best way to make money is in charging for originating the loans and perhaps on the sale of packaged loan-based financial instruments.
If those are the best ways to make money then the goal of any of these firms is to make as many loans as possible on the largest amounts possible – because origination costs most times are based on a percentage of the loan value, and sell as many mortgage backed securities as possible.
The danger is if the firms don’t need to carry the loans to completion, then what’s to stop them from caring about quality and ability to pay? And what happens when you run out of jumbo loans for the greater than 800 credit score people but the shareholders still want more?
Adding more fuel to the fire, the loan originators are packaging large amounts of loans together. That makes investigating individual loan quality extraordinarily difficult for their buyers. And their buyer, the Fed, is a buyer who essentially is forced to continue purchasing mortgage backed securities at an extremely hungry rate. A desperate buyer typically isn’t a picky buyer.
With no real checks and balances in the system (like loan originators having to carry the loans they make or loan buyers being able to stop and check quality), it’s becoming more apparent that it’s not a supply side issue that creates the conditions for 88 buyers offering up to 70% over value on a fixer upper or that used luxury cars are selling like hotcakes. It may be unbridled credit causing a demand spike. Even though people say these buyers are vetted much more closely than in 2007, we have to remember everyone thought that lenders were doing their diligence then, too.
When it all gets put together, it may not be poorly understood financial instruments that will again lead us to scary times. It will be a Fed and Treasury that needs to buy anything from people who may be ready to sell anything to anyone for a short term profit.