Crisis of risk aversion

September 20, 2008 at 6:55 pm | Posted in credit, economics, Housing | Leave a comment
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I think, and some people wiser than me think, that this whole crisis was created, not by too much risk taking, but by too little. Investors had money to invest, and tons of potential investments. They could invest in startups, or corporate debt, or in biotech R&D ventures, or in retail – They had the option of investing in just about any area of our economy.

But they invested disproportionately in two areas – First, in treasuries – safe paper. The other area they invested in was also supposed to be just as safe, but could let them eke out a few extra points of interest – mortgage securities of all stripes. They were very complex, and a single security contained as many as tens of thousands of underlying mortgages. This was too much data to handle, in terms of the quality of each underlying mortgage, and the derivatives on this became ever more complex. The investors did not have the time, the data or the ability to understand them fully.

But the credit rating agencies said that they had studied these mortgages, and their models predicted that the losses in the portfolio would be modest, so the investors piled in. The problem was, the models were wrong. The models assumed that house prices would always keep going up, and thus, that refinancing would never be a problem. Wrong on both counts.

All it takes is a close look at the economy – where have all the record profits of the past 5 years gone? Where is the big spending? Where is the corporate expansion? Where is the massive R&D? The investments?

It all got crowded out by the least risky option – Not by someone swinging for the fences with their investments, but by someone hoping to approximate the safety of a treasury with 27 extra basis points of return.


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