by Calculated Risk on 7/14/2005 11:47:00 AM

A couple weeks ago on Angry Bear, I quoted Econobrowser's Dr. Hamilton who asked: If there is a housing bubble,

"[W]hy are banks making loans to people who aren't going to be able to pay them back?"

To try to answer Dr. Hamilton's question, I suggested we try to identify who would be left holding the bag and work backwards to motive.

Caroline Baum touches on the same topic in Enough About Loans. What About Lenders?

Forget the borrowers for a minute. Who's making these arguably risky loans? Why are lenders extending credit to seemingly bad credit risks?

One answer is that they aren't taking the risk. Rather, the risk is spread out, diluted. Lenders sell the loans, or the loans are securitized, in which case investors assume the risk.

As Federal Reserve Chairman Alan Greenspan reiterates, highly efficient capital markets in the U.S. diversify the risk, transferring it from those who don't want it to those who do.

Still, ``someone is taking on a lot of risk for someone to be able to take on less risk,'' [Michael Carliner, an economist at the National Association of Homebuilders in Washington] says.

Spreading the Risk

Then there's the question of whether risk is being priced correctly.

``There's been a dramatic explosion in lending to people with poorer credit-management history, and not a lot of history how certain loan products will perform,'' says Doug Duncan, chief economist at the Mortgage Bankers Association in Washington. ``We have no experience in 10-year interest-only mortgages.''

The risks apply to all parties in the transaction, Duncan says.

``For the borrower, did he understand how the loan would change?'' he says. For the servicer of the mortgage, ``did he understand how the loan would perform? Would it pre-pay faster, go delinquent? For the investor, did it achieve the yield expectations?''

OK, so the risk is spread out among various parties. Still, banks and thrifts do hold loans, especially ARMs, Duncan says. Won't they get stuck if the value of the house goes down, the borrower defaults and the lender can't recoup what was owed -- multiplied many times over?

But this still doesn't identify the bagholders. Fannie Mae? Hedge Funds? Are investors underestimating the risk? Just more questions ...