Moral Hazard Here, Moral Hazard There

One of the major themes in this story is that of moral hazard. If we recall the classical mortgage model, banks originated loans to borrowers and the banks held those loans, receiving principal and interest.  In this situation, the bank is highly motivated to perform due diligence on the borrower. What is the borrower’s FICO score? Do they have a history of credit problems? How much other debt does the borrower have? Has the borrower’s income and employment been verified? All of these things are crucial to the lender if they want to minimize the possibility that the borrower will not be able to pay off the loan. We call the inability of a borrower to repay a loan “defaulting” and when many borrowers default on loans at the same time, the lenders lose a lot of money.

All of these due diligence questions that we have discussed can be summed up under the umbrella term “underwriting standards”. Underwriting standards refer to the level of scrutiny the bank performs on the borrower. For the bank, the upside of stricter underwriting standards (more due diligence) is that the bank will most likely weed out risky borrowers and there will be less defaulting loans. The downside, however, is a lost business. All the risky borrowers that the bank declines because they don’t pass the stricter due diligence are lost business. It is a trade-off that banks must consider.

But wait. Banks no longer give loans to borrowers and then hold these loans until they are paid off. Most loans are securitized in mortgage pass-through securities! There is an inherent moral hazard now. The banks no longer have to worry about performing detailed due diligence on a prospective borrower. Because really, the bank doesn’t care that much if the borrower defaults: they no longer hold the loan! The loan has been securitized in a mortgage pass-through security and sold to an investor.  And so underwriting standards got less and less rigorous – lenders allowed individuals to borrower without verifying information and many individuals that would never have been able to borrower before, were now getting approved for large loans. As the story unfolds we will see that these borrowers would never be able to pay back these loans.