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Mortgage Lenders Bet on Blue Skies Forever

Banks, like hurricane insurers, miscalculated their risk. But you can still make money in this market.
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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) - Get Goldman Sachs Group, Inc. Report

, 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.

Both mortgage defaults and hurricanes can be categorized as low-probability, high-consequence events. It's a type of phenomenon I examined during my Ph.D. at Wharton's Risk Management and Decision Processes Center under Paul Kleindorfer and Howard Kunreuther.

In both mortgage lending and insurance, the key to success is correctly judging -- and pricing -- risk.

Insurers have become much better at this, but until Hurricane Andrew struck in 1992, the Florida insurance market was subject to a boom-and-bust cycle: After each storm, consumers rushed to insure their homes, and insurance companies increased rates.

Then, as the years passed without another storm, fewer people would insure their house (ah, how short our memory is) as the disaster became less vivid in their minds, and insurance companies, hungry for business and facing increased competition from new entrants, reduced rates.

The trend continued until the next hurricane struck, and many, if not most, insurance companies went bankrupt because of too-high losses and insufficient capital.

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Why were insurers so shortsighted? For the same reason mortgage lenders are: They ignore long-term risk to satisfy Wall Street, which is focused on short-term profits.

How the Risk Spreads

There is another, less obvious reason banks misjudged the risk in mortgage lending, one that is well understood by insurers. This is the underlying dependence in terms of risk between insured -- or mortgaged -- properties in the same area.

For example, a hurricane in New Orleans threatens


New Orleans properties, not only some of them. Insurers will either have to pay claims for damages on no properties or a lot of them. (Think of the difference between making bets either $1 at a time or with
all your money on one number at the roulette wheel.)

Normally, whether or not one homeowner defaults on a mortgage has little bearing on the ability of another homeowner in the same area to pay. But the higher rates that were prevalent earlier this year put downward pressure on housing prices, and that in turn prevented some borrowers from refinancing properties because they didn't have enough equity.

The banks, in a knee-jerk reaction, tightened borrowing guidelines, thus preventing even more borrowers from refinancing.

The risk of default, especially among subprime mortgages, became a case of all-or-none, much like risk of damage to properties in a hurricane-prone area.

The phenomenon started in subprime mortgages, which were most susceptible to becoming correlated, but as borrowing guidelines tightened, mortgages normally considered less risky became correlated as well.

Now you can see why lowering the rates at which banks borrow money won't make it easier for consumers to borrow. The problem is no longer the level of interest rates. The problem is that banks are highly risk-averse, although most likely too risk-averse. They cannot unload those risky mortgages on other banks (the big Wall Street ones) and they don't want to face those now-correlated risks.

Of course, this means that risky loans are priced too low right now, and anyone who buys those mortgages now -- as

Bank of America

(BAC) - Get Bank of America Corp Report

is doing with its purchase of

Countrywide Financial


-- will probably make out well, because they can pay less than their true value. (Although you have to wonder if Bank of America bargained long enough, and strongly enough, with what is a distressed seller facing foreclosure.)

So cheap money won't induce banks to change borrowing guidelines. As long as borrowing guidelines are tight, few consumers will be able to borrow -- although those who can borrow will enjoy low rates.

Expectations that we are headed for a recession aren't exactly helping, either.

Therefore, the housing market will continue to stagnate, prices will continue to go down, and defaults will continue to rise, because borrowers cannot refinance their adjustable-rate mortgages once the rate rest.

Naturally, banks will continue to respond by becoming even more risk-averse, which is at this point a self-fulfilling prophecy.

What's the solution? Make borrowing easy, but not so easy that it brings about what we've seen in the past several years.

Will it happen? No, so brace yourself to surf the breaking wave. You can make a lot of money if you have good credit and you know what you are doing.