MORAL HAZARD AND MBS
Mortgage finance is conceptually simple. A saver lends money to a homeowner so he can buy a house. He then pays her back in installments, principal and interest, until the loan is extinguished. These flows of money were traditionally piped back and forth between savers and homeowners by local savings banks, or thrifts, designed for the purpose. Over the years, however, the "plumbing" to convey these flows has evolved into a nightmarish Rube Goldberg machine of securities, derivative instruments, vehicles, and intermediary markets.
Moral hazard neatly encapsulates one thing that can go wrong with this complex system. People may try to to over-exploit the money-flows, thinking that "just a little more" can’t hurt when the amounts are so enormous. Furthermore, they likely think any damage will ultimately be made good by something like insurance or a government bailout. Let’s have a look at where these attitudes might lead now that the historic housing bubble has burst.
