It’s Meltdown Time Again

How odd that so many business-news pundits are “shocked” by the recent credit crunch affecting investors in mortgage-backed derivative securities.

To be sure, the situation is a disaster. The equity and credit markets have been hammered almost daily by announcements of financial institutions closing or suspending operations of funds invested in securities backed by sub-prime loans. And despite falling treasury yields, mortgage rates have risen dramatically for non-conforming borrowers, further damaging the ability of shaky homeowners to refinance out of expensive ARM and Interest Only loans into something with a lower fixed rate.

But what caused the problem? Nothing new—it happens on a regular basis. Financial institutions with little oversight take ever-increasing risks and eventually pay a steep price when the markets become volatile. Remember the Savings and Loan crisis? Remember the Junk Bond meltdown? Remember the mortgage REIT disaster? Remember the Long Term Capital fiasco? All the same, and all tied to the mispricing of options.

During periods of low volatility, money managers tend to increasingly minimize the risks they are taking. The longer markets stay calm, the longer participants assume they will remain calm into the future, building those assumptions into their pricing models. And what instruments depend heavily on such predictions for their value? Options.

For example, the S&L crisis occurred because poorly regulated savings banks were motivated to take larger and larger risks with their investment portfolios to compensate for dwindling loan volume in the face of a cooling real estate market. But as interest rates fell to support the real estate market, the investment portfolios lost billions because they were stuffed with highly risky securities with embedded options, such as IO’s and Inverse Floaters backed by mortgages—the same instruments that had burned several mortgage REITs years earlier.

Long Term Capital collapsed because award-winning finance gurus bet the firm’s money on option-pricing models that failed to properly assess real-world risks. And the Junk Bond fiasco occurred because investors failed to properly value the risk of default on sub-investment-grade paper.

In other words, instruments that rely on sophisticated predictive models for pricing are notoriously difficult to manage. And hedge funds have become the S&L’s of the present moment. They are virtually unregulated, and many have invested heavily in the most risky and volatile securities, mortgage and/or credit derivatives. How else could they achieve their stellar results? Reward, after all, is commensurate with risk.

In many ways, however, hedge funds are a scam. Their managers have little direct investment themselves, usually something nominal to give the appearance of a stake but nothing compared to the fees they can earn, and they are compensated lavishly. Their fees come from a percentage of the size of the fund, usually 1-2%, as well as a huge portion of the fund’s appreciation in any given year, usually 20% of the gain.

This scheme motivates the managers to take enormous risks and thereby reap enormous rewards…until the fund fails, whereupon the managers lose their income streams while the investors lose their equity. If you’ve made tens or hundreds of millions in management fees, you only sacrifice your reputation if the fund goes belly up. So you sit on the beach in front of your Hamptons mansion and wait a few years until the market forgets about you. Then you try your luck again.

Some managers are clever enough to get out of the way of a pending disaster, but many are not. And as the credit crunch continues to send ripples through the financial markets, we should continue to see further fund closures and red ink.

A federal bail-out of any of these gamblers would be an insult to ordinary Americans, adding to the greater insult of the recently changed bankruptcy laws that make it virtually impossible for individuals to escape financial catastrophe while insulating giant corporations from relatively insignificant losses.

If the feds want to help, they should police unscrupulous lenders and force them to disclose in a plain and understandable way the risks of today’s mortgage products. They should also regulate the hedge fund industry and find ways to keep managers from rolling the dice with other people’s money.

Until then, nobody should be surprised by the latest market meltdown. It’s just another chapter in a long, growing history of the market for derivative securities and the people who fail to manage them.

- JT Compton

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