So we've been dealing with this little liquidity problem in the financial markets for a couple of weeks now. It has affected not only the price of the securities containing the bundles of mortgages that lenders sell to investors; it has affected dang near everybody, from the lending operations that are laying off thousands and closing up shop to anyone invested in the stock market including the foreign exchanges, to people trying to buy or sell a home.
So why did this happen? Why did banks make so many loans to people that couldn't repay? Why did the rating agencies give investment grade marks to the securities that included these loans? Why did investors assume that the risk of default was sufficiently diversified away? Why did the individuals who sought these loans enter into such a risky proposition?
To answer a few of these questions: The borrowers were assured that their home values would only go up and that they could refinance when their rates reset. The lenders were just going to sell the loan to an investor, so it wouldn't be their problem if the loans defaulted. The investors relied on the rating agencies. I don't know what the rating agencies' problems were; they came to the realization that there was a problem way too late. Everyone was passing the hot potato, paying it forward, or playing financial musical chairs (pick your favorite metaphor).
I do think that the lenders had an ethical obligation not to make these risky loans. This is called predatory lending, and will likely be defined as such by the states or the US government soon. That's where I would cast the first stone. Several state legislatures are already at work on this since the feds haven't done anything about it. I mean, how hard is it to require a paycheck stub before you give someone money? And to get some reasonable assurance that a reset interest rate would be affordable to the borrower?
Robert McTeer, the former president of the Dallas Federal Reserve had a good column about moral hazard yesterday in the Morning News. I will note that his is the only finance article I have ever read that references Billy Joe Shaver. He is suggesting that the Fed bailout of the financial markets increases moral hazard because future risks will be assumed to have a floor. He ends up defending Bernanke's actions of helping to bail out the financial sector, though, as the fallout was so all encompassing.
If the industry just wants to pass the hot potato rather than regulate itself, we have institutions that can regulate it. But will we see the next crisis coming sooner? Keep your eyes peeled for exotic financial instruments.