Three Lessons from the Subprime Crisis

02/26/2008 12:00 am EST


Richard Lehmann

Publisher, Forbes/Lehmann Income Securities Investor

Richard Lehmann, editor of the Forbes/Lehmann Income Securities Investor, says the fallout of the subprime mortgage crisis is far from over, but some lessons can be drawn. 

The effects of the subprime mortgage market collapse, which began in the middle of last year, are still playing out some six months later. What was initially downplayed as an insignificant part of the mortgage market (5%) has proven to be the tail that wagged the dog.

Not only has its effect been much greater than advertised; it has demonstrated structural weaknesses in our securities markets which go well beyond mortgages—and well beyond our shores. Worst of all, it is a crisis whose magnitude cannot easily be quantified. Such uncertainty is intolerable in a free market system and leads to fear and panic, a condition that only subsides with certainty, [which] remains elusive.

There are a number of lessons we can draw from this experience. First of all, an AAA rating is no assurance of anything. It is a subjective opinion by rating agencies who compete based on what answers they gave to a client.

When we examine the history of how things went so bad, we see securities created with such complex structures that they become impossible to value except [with] complex models, which were subjective creations by the people selling the end product (CMOs and CDOs) and being rewarded by how profitable their creations were for their employer.

The fact is that no one—I repeat, no one—has a handle on how extensive the losses from the subprime debacle are going to be. Nevertheless, the rating agencies pretend to know and issue downgrades, then issue further downgrades to reflect the new “market” reality. In this situation, “market” reality tends to reflect the emotional state of the weakest hands, something short sellers will pounce on and magnify.

A second lesson here is that the magnitude of a financial miscalculation such as the CDOs represented is amplified by the use of leverage to create risks not contemplated by the securities’ owners, the rating agencies, or the bond insurers. Leverage was present both within the structure of the CDO and in the capital structure of many of the buyers, i.e., hedge funds.

The result was an aggregate leverage estimated at nine times or more [for instruments like] CMOs and CDOs [that] lack such liquidity. The result was a seizing up of credit in a variety of markets as the solvency of counterparties to various transactions came into question. It demonstrates just how fragile a financial system we are living with. Even more, it demonstrated that when crisis looms the powers that be (i.e., the Federal Reserve) really don’t have as much power as we suppose.

A third big lesson is that deficient accounting rules exacerbated the crisis. A rule requiring securities to be marked to market value is sensible in normal times. In the current crisis, where there is no real market, the rule forced massive write downs which precipitate solvency and counterparty-creditworthiness concerns that caused further write downs. This self-feeding effect is an exercise in neither truthfulness nor transparency and should not be allowed to get started.

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