How Someone Thinking Outside the Box Will Eat Wall Street's Mortgage-backed Lunch

The ongoing discussion of the credit rating agencies' failure to accurately rate mortgage-backed securities and derivatives based on them illustrates a problem that has received almost no attention: the financial instruments that the rating agencies are supposed to rate are simply too complex. That fact is abundantly evidenced by the fact that the investment banks that created those investments are booking enormous losses themselves because they didn't understand the risks. The need to bailout Bear Stearns, one of the doyens of the mortgage-backed market, only reinforces the point. Even the financial wizards who brewed up these instruments in their laptop cauldrons didn't understand them.

The credit agencies came into being in order to deal with complexity. Let's step back to the time when Model T's were an innovation and World War I remained in the future. Bonds were favored over common stocks in those days. An absence of inflation on an overall basis (and indeed a long period of deflation after the Civil War) made bonds an attractive investment, much more so than common stocks with their fluctuating values. With the advent of the telegraph, and rapid delivery of the mails through the railroad system, the financial markets had become national--and, indeed, international--in scope. The increased size of the financial markets presented an informational problem. How could investors in Boston know how sound a mining or timber company in Colorado might be? Accounting and other financial reporting in those days was less standardized than it is today, and by all accounts, dodgier. That may sound like something in light of Enron and all the surprise writeoffs these days by major banks. But many investors in those days paid more attention to the reliability of a company's dividends than to its earnings announcements because the dividend provided cash that you could use at the bakery and the haberdashery. Financial reports were often just pieces of paper that you could only use for . . . well, you know what we mean.

Part of the answer to these informational problems was the evolution of the credit rating agencies, which then as now focused primarily on the likelihood of bonds being repaid. By simplifying the investor's job of judging the creditworthiness of a company, the credit rating agencies made investing much easier. This, in turn, built up investor confidence and increased the liquidity of the markets.

The credit rating agencies' recent airball in the mortgage-backed and derivatives markets has spurred a debate about their manner of compensation (paid by the issuer, an obvious conflict of interest since no issuer wants to pay for an unfavorable opinion), their competence (their salaries aren't competitive with the best investment banks, so the presumption is that they can't hire the most capable people), the manner in which they are regulated, and the fact that they may have done more than rate CDOs and involved themselves in discussions about derivative structures (when it's not their job to design financial instruments). Change is in the air for the credit rating agencies. But that's the less important part of this story.

The real problem is that Wall Street makes big, big profits from innovations, especially complex innovations. New products can generally be sold for higher markups than established, well-known products. This is partly because people pay for novelty (ask clothing manufacturers about this). It's also partly due to lack of familiarity with the new products, especially if they are complex. A well-marketed new product that people don't fully understand might be sold at a high price because buyers are persuaded to over-value the product. This is the case with a lot of variable annuities, which are constantly being brought forth in new and ever more complicated structures.

The current crop of mortgage-backed securities, CDOs, and CDOs invested in CDOs also illustrate the point. This entire market was premised on the belief that residential real estate would never fall in value. But very few people seemed to have focused on the potential fallacy of this assumption, in part because mortgage-backed securities and derivatives were supposed to have magical qualities when it came to reducing risk. But when you tried to figure out if and how they actually reduced risk, you'd enter a labyrinth that contained a nasty Minotaur. We're now hoping for Theseus to make an appearance.

Reform with respect to the credit rating agencies could do some good. But Wall Street's profit incentives will lead it to create new and possibly even more complex financial instruments to replace the ones that are now discredited. Why? Because that's where the big bucks are, especially if you're focused on your year end bonus, and not the interests of investors in their retirements ten, twenty and thirty years in the future. The credit rating agencies, investors and other market participants will likely be challenged to understand and manage the risks of the next generation of high-falutin' things from the Street.

Because the profit incentives are for Wall Street to continue to pump out ever more complex products, there is an opportunity here for someone else to step in and seize some market share. Simplification and reducing costs for investors is something that Wall Street doesn't do. But others, unaffected by obsessions over who is seated where in which Midtown Manhattan restaurant, can do them, and make a lot of money at it. The discount brokerage business, which provides a comparatively simple and low cost product to investors, was created to a large degree outside of New York (especially by a guy in San Francisco named Charles Schwab). The mutual fund, although complex in its technical details, greatly simplifies the individual investor's job by providing packaged diversification, investment management, and accounting services, often at very economical prices. The mutual fund business is rooted in places like Pennsylvania and Massachusetts.

America's real estate markets have become heavily dependent on investor financing. The old-fashioned savings and loan, credit union funding of mortgages with customer deposit accounts won't provide enough loans to satisfy borrower demand. And we can't rely on Fannie and Freddie any more. Even with the government relaxing loan underwriting restrictions, market realities have forced Fannie and Freddie to effectively tighten, and not loosen, lending standards. It may be that Fannie and Freddie are becoming too big and complex to manage (especially from a risk management standpoint). Neither they, nor the FHA, are likely to burst out of a telephone booth and save the day here.

In order to attract investor money to the mortgage markets, new and simpler mortgage-based investments are necessary. There's nothing wrong with pooling mortgages and selling interests in those pools. But don't pretend that this reduces the risks of investment in mortgages, and don't try to turn lead into gold by purportedly shifting these risks through complex derivatives to counterparties that may stand you up at the worst imaginable time. If we go back to the 1987 stock market crash, portfolio insurance (a derivative) did little or nothing to protect equity investors from loss. Indeed, some believe portfolio insurance made the losses worse. Provide investors with full disclosure of the risks of investing in mortgages. In this case, full disclosure means full disclosure--people can accept risk if they know about it in advance. But don't create a complex instrument and then try to rely on disclosure. Even if you make legally adequate disclosure, investors will often be confounded by complexity and royally ticked off when they lose money. Design the instrument to be easy to understand, and investor confidence will rise.

Mortgage-backed investments should be standardized. This will make them more readily understood. It will also facilitate the creation and maintenance of liquid secondary markets, something that CDOs sorely lack.

The qualities of clarity, predictability and low costs that would characterize the next generation of mortgage-backed products aren't attractive to Wall Street's financial engineers. These aren't the kind of financial products that get an investment banker a mansion in the Hamptons quickly.

Someone in St. Paul, Kansas City, Boston, Philadelphia, Phoenix or Sacramento may well design and develop such a product. A great deal of the money invested in U.S. mortgages comes from overseas. Perhaps someone in London, Hong Kong, or who knows, maybe Helsinki, will design a competing product. Since there is so much demand for mortgage funding, it's likely that simpler, clearer and more easily tradeable mortgage-backed investments will be created. Just don't look for them to come from Wall Street.