A Sudden Realization About the Sub-Prime Crisis
By combining pools of mortgages with rising housing prices, lenders were able to wash off the risk because the failure of some percentage of borrowers still left the pool safely covered.That was the explanation I had read, but something bothered me about it. It didn't quite make sense that some juggling could improve the credit rating that much. After all, to really cover the potential default rates, you'd probably need to add a significant number of "good" mortgages that would be unlikely to default so the return on the investment had a reasonable chance of occurring. But then the default rates shouldn't have had that kind of impact. And yet, it seemed that the derivative securities were largely based on poor credit lending. How did bundling them get better ratings than the individual loans would have?
After paying attention to more reporting on the subject, I think I now understand. The rating agencies abdicated any ethical or moral responsibility to give an honest opinion on the derivatives because they are paid by the very financial institutions that were issuing them. Unfortunately, investors pay significant heed to these ratings and often pass on doing further due diligence. I could understand that from individuals who are intimidated by understanding financial matters. But these derivatives could never have taken off without significant institutional investor participation. What happened here? Don't these large organizations that hire lots of brainy people actually do their own thinking? Actually, many rely on the opinions of others far more than you might thing, certainly in proxy voting issues, as I learned in writing an article for Corporate Secretary.
So many individual investors, putting their money into money markets, pension funds, and other aggregations of cash might be taking a larger risk than they realize, because they don't always know who's really making the decisions. Where has the financial media been through all this? This story has an Enron-like cast, with lots of people writing in awe of the clever financing and no one pointing out that the Emperor ruled in the buff.