Naive Optimism

One of the things most unsettling about the current situation in the credit markets is that it makes me question the integrity of the financing system behind the boom in the mortgage securitization market and the financing markets in general.

While this headline may be motivated by an investor’s misplaced frustrations, when I see the rapid pace at which the system has unraveled over the last few months, I am inclined to believe that this will be the first of many such accusations:

Wall Street often shelved damaging subprime reports

In defense of the big banks (and not just because I used to work at one and I have friends at many), there is some validity to the concept that each issuance includes the words “past performance is not necessarily an indication of future results” for a reason. It is difficult to know when and how events will change, and people’s predictive abilities are massively hindsight biased.

For the same reason that people are more likely to laugh at a joke when the CEO laughs first, individual buyers and sellers in a market are unlikely to depart from historical valuation methods unless someone else moves first. This causes people to move late and then in a herd mentality.

As an underwriter, it is likely impossible to predict the timing of such movements, and if “valuation” is defined by the market’s willingness to pay for something, then in a very real sense, until that herd moves you are justified and in fact almost mandated to price things based on historical performance.

In this case, I have no doubt that the rating agencies, as helped by the banks, modeled hundreds if not thousands of scenarios in each securitization transaction. Through these “Monte Carlo” simulations, they felt justified in thinking that the past performance and correlations were sufficiently predictive of future pricing to “rate” the securities accordingly.

As an investor in such a transaction, the onus would then be upon you to question the underwriting techniques – to anticipate future changes…and to perhaps even use a bit of creative thinking to try to predict when the market and herd would move.

Unfortunately, during the financing boom over the last five years, both buyers and sellers lost sight of the reality of a deteriorating credit (the american homeowner) underlying the system.

Now that we are watching the cards fall down and reflecting on some of the bad investments in the rear view mirror, it is only natural to point fingers, and to doubt.

But as I reflect – my naivete wins out – and instead of litigation I reach for learning so that we can perhaps minimize the contagion in this cycle and learn to prevent it next time around.

3 thoughts on “Naive Optimism

  1. DAL

    The data from that Fed report is stale (i.e. as of Dec. 2006) and even at that time the trend was pointing upwards. Defn. a good sign that as of then prime mortgages were performing, but CFC’s earnings release last week confirmed that defaults are spreading to so-called “prime” borrowers. I would love to see an update.

    As for GDP growth: I wonder what it would look like in inflation-adjusted exchange-rate adjusted terms. The dollar is at an all-time low and inflation is still growing. Not sure what “growth” means in that context. Plus today showed a decline in consumer spending (“masked” by an increase in “confidence”, whatever that means).

    I am an optimist too. Just have to recognize dark clouds when I see them.

    Keep the comments coming. Good stuff.


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