It’s Time to Meet Subprime Devil We Don’t Know: Caroline Baum
Aug. 24 (Bloomberg)
Ever since financial markets went into their summer swoon, economists, analysts and journalists have been trying to explain why a small number of defaults on a small number of home loans morphed into a global liquidity and credit squeeze.
How on earth did the subprime mess come to this?
It’s not easy to comprehend or explain the linkages from loans to bonds to credit derivatives and back to loans (the unwillingness to make new ones of any kind!), which is why I’m taking another stab at it. This time around, I learned that the bigger threat is not what we know about these complex credit derivatives, but what we don’t know.
“The most interesting aspect of the ongoing subprime saga is not what it says about the U.S. mortgage market or the U.S. consumer but what it says about the impact a lack of transparency in financial market risk can have on markets overall,” writes Gail Fosler, chief economist at the Conference Board, a business research organization based in New York, in the July/August edition of “Straight Talk.”
That lack of transparency in risk has to start with a lack of transparency in the structures themselves. If an investor doesn’t know what he owns or what it’s worth, how can he assess the risk, not to mention hedge against it?
“Market risk is a major component of the rating,” says Joshua Rosner, a managing director at Graham Fisher & Co., an independent research firm in New York. With illiquid securities created by slicing and dicing pooled mortgages and other loans, “market risk is a greater issue” than credit risk, he says.
Raising the veil on these structured products might have tempered demand for them over the last few years. It surely would have smoothed what’s become a bumpy road today.
So how can we increase transparency in a complex market where everyone involved profits by keeping the investor in the dark?
One way would be “a large lawsuit by a well-capitalized institution,” says Sylvain Raynes, a principal at R&R Consulting, a structured valuation boutique in New York.
The primary market needs to develop “valuation standards,” which “could have avoided 90 percent of the problems,” he says. “It is possible to know a priori that a deal does not work, that the amount of securities in the transaction is too high.”
2 + 2 = 3
The deal may make “linear sense,” with $100 million in loans for $100 million of securities. “But the obligors are too risky for the bonds being issued.”
Given the opaque nature of the securities and structures, no wonder their risk isn’t obvious.
“The lack of transparency around risk creates an incentive for indiscriminate market turmoil because investors don’t know how to selectively implement their risk aversion,” Fosler says.
When things get dicey, the lack of transparency contributes to risk aversion. At times like these, the formula is simple: Don’t ask + don’t tell = sell.