The Real-Estate Bubble and Banks' Risk Management

Financial markets serve a lot of purposes. One of the main ones is to help individuals (and companies) manage risk. A big part of that process comes about because of financial innovation. The general rule I tell my students is that if you can come up with a new way to shift risk, you can make a lot of money.

One of the questions that's gotten a lot of play lately is, "If the real estate market is in a "bubble" mode, why do the banks keep lending?" The logic is as follows: if real estate is overvalued, then making floating rate loans (or non-down payment loans" will leave the banks holding the bag when mortgagees default.

The answer is, "The banks have passed the bag to someone else". Nowadays, many (if not the majority of) loans are "securitized". This means that the bank bundles a large number of loans together and then either sells them directly on the loan market, or issues securities backed by the portfolio. So, the risk is transferred to the purchasers of the loans/securities.

A recent New York Times article titled "A Hands Off Policy on Mortgage Loans" touches on this point and uses it to explain why banks have largely ignored the recent "guidance" issued by banking regulators on home-equity loans:

The main issue for regulators is whether banks and other lenders are properly managing their own risk, and the lenders are looking good.

They have hedged their risks by bundling mortgages into securities that are then sold to investors around the world. And if interest rates go higher, they have shifted much of the risk onto consumers because a growing share of home buyers have taken on adjustable-rate mortgages. At the same time, they have built sturdier financial institutions through mergers and the breakdown of barriers to interstate banking.

Bert Ely, an independent banking analyst who was among the first to recognize the crisis at savings and loan institutions in the 1980's, said the banks are far sounder today. "It's a night-and-day difference," Mr. Ely said. "No comparison."

Click here for the whole thing.

Hat tip to Calculated Risk for the link.