The loose underwriting standards in home mortgages coupled with the shifting of risk perpetuated a venue for incubating moral hazard. The consequences were destructive to on and off balance sheet of banks.
As a Qualitative Asset Transformer (QAT), banks are rewarded for mismatching the two sides of the balance sheet- assets and liabilities or loans and deposits, and these create risks. As typically, the bank’s assets has greater credit risks than its liabilities. However, in recent years it has reached an unprecedented level, an example of which is when Moody’s Investors Service announced that it’s raising its loss expectations for US subprime residential mortgage-backed securities issued between 2005 and 2007, as it believes, without intervention, nearly all already-delinquent loans will eventually default.
Also, bank’s assets have usually longer maturities than liabilities, creating interest rate risk. These risks were inherent during the period of 2002-2004 when the federal funds target rate was in the average of 1.25% and loans that are adjustable rate mortgages (ARMs) were prone to prepayment.
Lastly, a bank’s liabilities are more liquid than its assets. When a depositor demands his money without notice, while the bank’s assets, such as loans cannot be traded in an active market, there is a liquidity risk. As what recently happened with the largest bank failure of Indy Mac Bank in summer of 2008, due to their enormous exposure in exotic/option loans, depositors doubted the bank’s viability, thus they withdrew their money. Similarly, the seizure and sale of Washington Mutual to Chase and Wachovia to Wells Fargo are examples of liquidity risk. These banks were required to mark-to-market or estimate the fair value of their assets, particularly the mortgage backed securities, at a time where the market for these assets were not active.
Over recent years, the rapid growth of banks’ off balance sheet exposure can be attributed to deregulation, technological and financial innovation. This has provided enormous opportunities, nevertheless it created a competitive environment. Most profits from conventional on balance sheet activities have been diminishing, thus banks have approached it aggressively in an effort to keep relationships with current clients intact and to increase fee income from other sources.
The most controversial of the bank’s contingent claims are the credit default swaps. The CDS market exploded over the past decade to more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association. This is roughly twice the size of the U.S. stock market (which is valued at about $22 trillion and falling) and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market, notes Harvey Miller, senior partner at Weil, Gotshal & Manges.
These insurance-like contracts that promise to cover losses on certain securities in the event of a default have been difficult to value lately. What makes it more challenging is that at this time, most banks wrote down their mortgage related securities.
Considering that the banking industry is in turmoil, public regulatory agencies, including Federal Reserve, Office of the Comptroller and Currency, Federal Deposit Insurance, needed to step up. It has been criticized that during good times, when profits were flowing, rewards have been privatized, but now that inefficiencies in the financial markets exist, risks have been nationalized. Most of the risks inherent in the lending industry are now being absorbed by the government. This scenario creates moral hazard, as it signals that a party shielded from risk may behave differently from the way it would behave if it were fully exposed to the risk. The idea that financial institutions did not bear the full consequences of their actions, as they acted less carefully than they otherwise would, leaving the government to bear the responsibility for the consequences of their actions.
Endnotes:
-Basel Committee: The management of banks’ off-balance-sheet exposures: a supervisory perspective. Bank for International Settlements. Bis.org. March 1986
-Morrissey, Janet. Credit Default Swaps: The Next Crisis? Time.com. March 17, 2008
-Curran, Kelly. Subprime-Mortgage Defaults to Surge: Report. Housingwire.com. Feb 26, 2009
-FDIC Announces Plan to Free Up Bank Liquidity. Creates New Program to Guarantee Bank Debt and Fully Insure Non-Interest Bearing Deposit Transaction Accounts. October 14, 2008
-Zacks Investment Research. The Moral Hazard Of Bailouts. Dailymarkets.com. February 19, 2009
-FDIC Announces Plan to Free Up Bank Liquidity. Creates New Program to Guarantee Bank Debt and Fully Insure Non-Interest Bearing Deposit Transaction Accounts. October 14, 2008
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