Moral Hazard......

[fuji]

This is the most important point, the underwriting function is performed by a bond ratings agency that's hired by the firm securitizing the debt.... the only risk they have is reputation risk. If a firm (AIG for instance) or quasi government agency (Fannie, Freddie) insures that risk then the underwriting standards are their responsibility (and thus not much moral hazard, until we get to the below).

It's not only that. There is moral hazard in the very concept that the originating "lender" is not actually on the hook for the loan. Via securitization they are lending out other people's money. Whenever the phrase "other people's" comes into play you should be wary of a moral hazard.

Banks are ALMOST a moral hazard by definition: They operate by lending out other people's money. Almost, but not quite, because in the ordinary situation they are on the hook for any losses anyway. You deposit $100 into your bank, your bank lends it to me, i fuck off to cuba and the bank STILL owes you the $100 back, they can't say, "fuji fucked off to cuba, go chase him for your money". Securitization weakens that.

This is a dumb point, there is a reserve requirement for this reason. The risk this addresses is liquidity risk.

The moral hazard is that they can take risks with other people's money, earn large profits from those risks ,but their losses are limited.

Another good point, and one that I doubt will be properly addressed anywhere......

This, in my opinion, is actually the BIGGEST problem with finance: the compensation system.

Here's the substance of the finance "game" -- le'ts consider an investment with a 9 in 10 chance of paying off $1 every year, and a 1 in 10 chance of losing $15. This business loses money over time, but in 9 out of 10 years it earns a "profit".

The finance game is that your bonus is a percentage of $1 in 9 out of 10 years, and a percentage of 0 in the other year. It's a scam.