Financial markets as asset-backed securities

Several lessons can be learned form the financial crisis. The first lesson regards the issue of the disclosure of financial information and the influence it has on the decisions made by the investors. In this regard, it can be learned that the disclosure was not sufficient. This was so from the fact that the housing market surpassed reasonable scenarios of worst-cases.

The implication here is that mortgage loans which acted as the asset basses which supported mortgage-backed securities (MBS) along with a large portion of the collateralized debt obligation (CDO) as well as asset-backed securities (ABS) CDO asset securities, eventually materialized to be adversely not correlated. What is meant is that any slight fail to predict the real worst-case situation, to a relative degree, a fail to take along-term perspective of risk. Some provide an explanation to the almost collapse of long-term capital management (LTCM) as being a direct result of the above failure.

Investors as well as other market participants looked to the past events as an illustration of what occur to the prices at home, though they always failed to consider the worst-case scenarios like the incident of the Great Depression. There is need to learn that such kinds of failures are difficult to avoid since worst-case scenarios are arrived at through the process of judgment. The other lesson which can be learned from the sub-rime crisis is the fact that the disclosure could have been adequate except for many investors failing to carefully examine and eventually appreciating it.

It therefore means that several factors could have led to the sub-prime crisis. One, the investors could have heavily over relied on the third parties in charge of arrangements concerning the sake of their securities. Granted, the investors have the discretion of relying on third parties though the reality could be that they do not take the requisite responsibilities of perusing the documents in a bid to understand all the inherent risks. Such investors could still have the notion that the underwriter would consider their interests.

It implies that such investors are yet to understand the important need to undertake a negotiation of complex bilateral agreements. This brings about the issue of caveat emptor, in which case, it seems unreasonable except in a situation where the interest between the underwriter and the arranger are aligned together in line with those of the investors. Well, the above interests were in a way aligned, though, in the case of ABS CDO transactions, underwriters bought customarily, some proportion of the ‘equities’ in a bid to illustrate the belief they had in the securities which were being issued.

The implication in this context is that the alignment of the interests of both the sellers and the investors could have worked contrary to the caution of the investor. At the same time, the other lesion which could be learnt is that the investors may have heavily relied on rating agency-ratings, without the necessity of undertaking their own due responsibility. What needs to be noted is that even if investors had undertaken their own diligence, agency-cost conflicts coupled with an absence of economies of scale may have been the contributing factors  towards a limited extent they assessed the creditworthiness more that the agents.

Still, the other lesson could have been that that resulting from a market boom, many investors embraced the period, in the process failing to pay detailed attention to buying. A boom usually starts easily. For instance if a particular stock appreciates unexpectedly, the losers tend to draw away from that particular market while the winner will tend to be drawn to it, with the resulting process shooting even the more. Eventually the winners will get more interested in the stock while the losers will undergo loses stopping to short the particular stock.

Usually, this process is a quite misunderstood phenomenon more so concerning the ‘rationality’ of the upward movement of the price as well as the irony of why the fundamental relationship of price to earnings is inapplicable. What is meant here is that even those investors who appreciate the irrationality of the bubble may still purchase the stocks, with the intention and hope of reselling them at the high price before the prices fall down. In this way, somehow the movement of the price is in way self-sustained.

As compared to the tulip ‘bubble’ during the 17th century in Holland, in which case, some tulips were extremely high prized and the selling prize for their bulbs was fixed at a thousand guilders. Virtually all people got entangled in the process of buying and selling of the tulip bulbs, which mostly happened on credit and with an intention of achieving fast returns. However, many investors who speculated on credit terms ended up with serious debts when eventually the market came crumbling down.

What needs to be noted here is that occasional booms are at times inevitable in a market economy. The thirds lesson which could be leant from the subprime crisis is based on the concept of rationality. Boom usually does not need the rational behaviour of the investors. On the converse, investors occasionally could make decision which may not be correct, even with disclosure, owing to the issue of bounded rationality. This has the potential of happening in two ways. In some way, failure of the investor in the subprime crisis may have occurred as a result of the mass behaviour.

At the same time, the subprime crisis could have been caused as a result of the presences of heuristic, in which case, the investors over project the probability of events similarly occur in the minds of them people. For instance, in real life, people tend to overestimate the rate of divorce more so in case where they can easily establish the number of divorced colleagues around them. In the same way, one historical financial crisis is eroded in the memories of investors more so on the case where an opportunity to make more money arises, in which case, the investors would rush for the golden opportunity.

The other lesson which can be learned from the crisis is that the disclosure could as well have been totally inadequate owing to the complexity of the transactions which the investors could not understand. Should this lesson be true, it would support the idea of a change in paradigm with regards to investors in an Originator’s securities to the investors of SPV’s securities. The idea proposed here is that investors dealing in Originator’s securities need to be offered supplementary protection which is achievable by restraining conflicts of interest, for which it would be insufficient to disclose.

The applicable rationale here is that with the lack of conflicts, the management of the Originator is liable to make decisions which would closely reflect only the interests if the Originator investors. The other lesson with regards to the subprime crisis involves the issue of risk. In this regard, even if disclosure is sufficient and fully understood by the investors, disclosure in itself is insufficient to fully account for systemic risks which are inherent in any financial market. Systemic risks are those risks that are caused by the results of undesirable economic events like institutional failures.

What is meant here is that these economic shocks, which are the causes of institutional failures, usually result into other series of market failures or significant financial losses that are usually manifested in volatile prices of financial markets. In this case, disclosure alone will be insufficient in preventing systemic risks owing to the fact that, like common tragedies, the merits which usually accompany the exploitation of finite capital resources accrue to individual participants in the market.

Each of these participants always has a motivation to fully utilize the resources, whereas the exploitation costs, which usually have a direct effect on the real economy, are spread amongst many individuals. What this means is that systemic failures cause externalities which could spread beyond the participants in the market, in which case investors are not likely to care about the issue of disclosure when it pertains to systemic risks. The other lesson with regards to subprime crisis concerns structured finance.

It could as well been true that structured finance permitted not only easy entrant but also undisciplined lending for the purposes for mortgages, by allowing mortgage lenders to sell loans as soon as they are made. This had the moral danger that the mortgage lenders did not have to consider the credit consequences of their loans. The implication here is that the lenders were actually in a position to make money depending in the volume of loans which they generated. Therefore some mortgage lenders who did not even have financial statements could have taken advantage of this by advancing to borrowers the loan proceeds.

Eventually this led to the sharp decline of mortgage lenders underwriting standards. Still, it could be possible that some mortgage lenders could have involved themselves in fraud by manipulating the income from the borrowers, while some borrowers themselves could equally have lied about their incomes, in both cases with the intentions of qualifying for loans. One solution to the above would be to put limits on the originate-and-distribute model which the mortgage lenders were using. This model is important to the funding of not only the liquidity banks but also many other corporations.

An even better solution would require both the mortgage lenders and the originators to account for a risk of loss. In many security transactions which are not mortgage in nature, it is the practice of the Originators to be the bearers of direct risks of loss through over collateralising the receivables. This practice is usually not practiced in mortgage securitization owing to the fact that mortgage loans are inherently over collateralised by the valuation of the real-estate collaterals. This has the implication that investors are capable of being over collateralised even with the Originator bearing no risk of loss.

However, there is need to do this in order to mitigate moral danger. The other lesson which can be learned from the subprime crisis with regarding to risk is that possibly, structured finance could have widened the subprime mortgage risk in such a wide way such that there was no identified incentive for the investors to asses it. The lesson here is that structured finance usually in salutation, diversify and reallocate risk. The question then is whether in the case of subprime crisis, structured finance over dispersed subprime risks.

If it is true that it over dispersed the subprime risks, then the concern would be whether there is need for the realignment of incentives in a bid to promote monitoring, more so by reducing the extent of the dispersion of risk. Structured finance has the capability of inhibiting the determination of problems of fundamental asset class. For instance, in this case, structured finance made it cumbersome to establish the underlying mortgage loans owing to the fact that the owners who were supposed to benefit were not the mortgage lenders any more but a broad diversity of investors in the financial markets.

The effects of these were unnecessary high losses in mortgage defaults. Today, many owners of homes are not able to restructure their loans since they cannot define those who own the loans. However, the legislation by which the mortgage borrowers are protected indicates that this could be an overstated concern. The implication from the above indicate that structured finance makes it cumbersome to determine problems associated with mortgage loans, though the increased difficulty is capable of being dealt with.