Mortgage Lenders Bet on Blue Skies Forever

The Federal Reserve thinks it can fix the mortgage crisis by throwing money at it.

It should think again.

The central bank has raised the amount of liquidity it will inject into the banking system this month through a new auction facility by $60 billion. It already pumped $40 billion into the system through the facility in December.

Wall Street likes the cheap money, and it should, because it means banks will do better by making more profitable loans then they would have otherwise.

But the Fed's actions won't change the dynamics of the mortgage market. It will still be difficult for consumers to borrow money, and that means housing prices will continue to fall. To understand why, you have to understand the underlying reasons for the crisis.

The Nature of the Risk

Banks are not averse to lending because credit is tight. They are averse to landing because they found out they are not so good at judging risk, and because they can no longer unload those bad risks and make a quick buck in the process.

With the exception of Goldman Sachs(GS), pretty much everyone on Wall Street is guilty of misjudging the risk. (Goldman may well have misjudged the risk initially, but it recognized when the market was turning and got out in time.)

To understand why banks misjudged the risk of subprime mortgage lending so badly, it helps to look at another market with similar characteristics: property and casualty insurance in areas suffering from hurricanes and other natural disasters such as hurricanes, earthquakes or wildfires.