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'Moral Hazard' Helped Stoke Subprime Fire
By Ted Cornwell
In thinking about how so many risky loans were made to borrowers with weak credit histories, it is important to understand the perceived incentives that loan underwriters and originators had during the heady subprime lending days before the crisis began to unfold, according to some experts who have studied the issue.
During a recent teleconference on the subprime mortgage crisis sponsored by the American Bar Association, Richard DeMong, a professor of bank management at the University of Virginia's McIntire School of Commerce, said that "moral hazard" in the home loan system played a large role in the still unfolding deterioration of credit.
"Many players in the mortgage market face a risk that they thought they had diversified away because of securitization," Mr. DeMong said. Loans that involved little or no documentation of income accounted for a big share of subprime home loans in 2006, he noted.
What those lenders have found, through buybacks and margin calls, is that they hadn't divested themselves of risk as thoroughly as they may have thought.
Mr. DeMong pointed out that this isn't the first time credit standards in the home loan business have deteriorated. He said that those who argued things are different this time may have been fooling themselves.
Indications of emerging problems were there to see before defaults started to skyrocket and subprime lending firms started to close shop or seek bankruptcy protection, he noted. Hedge funds had been shorting the stocks of subprime lenders. And indexes that track the subprime industry had started to slip in January of this year.
Mr. DeMong points out that a surge of liquidity, much of it from foreign investors, helped to drive down risk premiums in the securitization market and make the subprime boom possible. Even today, despite the liquidity challenges facing subprime lenders, corporate debt spreads are below their historical average, he noted.
Does that suggest a new subprime crisis, reminiscent of 1998 or 2007, could happen again in the future?
"History will tell us whether we really did learn a lesson or not," Mr. DeMong said.
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