Like spdrun said, it stokes the demand for **riskier** products that offer higher yields.[/quote]
With underwriting standards that existed before the bubble, those products wouldn’t have been “riskier”. S&P and other ratings agencies called them low risk. Not the Fed.[/quote]
Again, the reason for the lower underwriting standards was the desire/need to take on more risk (because of the low rates/Fed). Changes in mortgage securitization and derivatives enabled the lending standards to fall through the floor…and allowed the credit rating agencies to give the products high ratings. Everybody was making speculative bets because everybody was looking for higher yield/higher-risk “financial innovations.”
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“Widening the Margins
Thanks to an exploding real estate market, an updated form of the ABS was also being created, only these ABSs were being stuffed with subprime mortgage loans, or loans to buyers with less-than-stellar credit. (To learn more about subprime, read Subprime Is Often Subpar and Subprime Lending: Helping Hand Or Underhanded?)
Subprime loans, along with their much higher default risks, were placed into different risk classes, or tranches, each of which came with its own repayment schedule. Upper tranches were able to receive ‘AAA’ ratings – even if they contained subprime loans – because these tranches were promised the first dollars that came into the security. Lower tranches carried higher coupon rates to compensate for the increased default risk. All the way at the bottom, the “equity” tranche was a highly speculative investment, as it could have its cash flows essentially wiped out if the default rate on the entire ABS crept above a low level – in the range of 5 to 7%. (To learn more, read Behind The Scenes Of Your Mortgage.)
All of a sudden, even the subprime mortgage lenders had an avenue to sell their risky debt, which in turn enabled them to market this debt even more aggressively. Wall Street was there to pick up their subprime loans, package them up with other loans (some quality, some not), and sell them off to investors. In addition, nearly 80% of these bundled securities magically became investment grade (‘A’ rated or higher), thanks to the rating agencies, which earned lucrative fees for their work in rating the ABSs. (For more insight, see What does investment grade mean?)
As a result of this activity, it became very profitable to originate mortgages – even risky ones. It wasn’t long before even basic requirements like proof of income and a down payment were being overlooked by mortgage lenders; 125% loan-to-value mortgages were being underwritten and given to prospective homeowners. The logic being that with real estate prices rising so fast (median home prices were rising as much as 14% annually by 2005), a 125% LTV mortgage would be above water in less than two years.”
Cheap money encourages risky, speculative financial activity; it causes risk to be mispriced — which is why the ratings agencies were not accurately rating the various securities. It does not necessarily encourage productive investment (I would argue it does exactly the opposite).
