Don’t be too overly optimistic that mortgage-backed securities are the only dodgy financial instruments out there. Consider this analogy: People with whom I have worked know my office usually is a mess. Can they safely assume that my home office is a model of efficient organization, that all my tools are in exactly the right spot in the garage or that Martha Stewart would envy how neatly I have arranged the storage in our attic? Not on your life!
Over the last 30 years, financial wizards with degrees from the nation’s finest business schools have engineered a variety of innovative ways to turn bread-and-butter mortgages on houses into increasingly complex financial instruments. We now discover that the people who designed these securities made fundamental errors, underestimating how risky they might become.
So did big financial firms like Bear Stearns and Citigroup. So did rating agencies like Moody’s. So did bond insurers like Ambac. We may find over time that pension fund, mutual fund and nonprofit endowment fund managers did, too. Even professors who write finance textbooks didn’t see how much trouble could be coming.
If financial institutions made fundamental errors in pricing the risks involved in various types of innovative securities backed by mortgages on houses, how can we be sure they were right-on in their analyses of the risks of even more complex new financial instruments? If they are getting a D- on home mortgages, will they get even a B+ on securities backed by commercial property mortgages, credit-card loans, auto loans or loans for private-equity firms to fund leveraged buyouts?
One of the mysteries of financial market problems thus far is why a problem as limited in size as defaults on subprime mortgages is causing so much Sturm und Drang among financial institutions.
Adjustable-rate mortgages cover only a fraction of all homes. Subprime loans make up only a fraction of all adjustable-rate loans, and only a fraction of these go bad. Moreover, most foreclosures end up with the lender recovering much of the principal owed.
If only a limited proportion of home mortgages go bad, why is there such enormous unease in financial markets right now?
This is not to minimize the enormous difficulties foreclosures involve for affected families nor any broader effects on the U.S. economy. But levels of home mortgage write-offs probably are not large enough to explain all the current distress in financial markets. Financial institutions clearly are worried about more than just mortgages.
This is not a Chicken Little assertion that the entire sky is falling. There is a great deal of resiliency in financial markets. But recognize that unfolding problems in the financial sector are broader, deeper and more complex than is implied by the phrase “subprime mortgage crisis.” Don’t assume we are nearly out of the woods. We probably are not halfway in yet.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.