As the collateralized debt obligation (CDO) news continues to get worse and more subprime mortgage lenders -- and subsequently, hedge funds -- shut down, one wonders how the market worked itself into such a mess. After all, when the subprime market began to take off a number of years ago, economists offered warnings about the dangers of providing loans often worth as much as 90 percent or more of a home's value to individuals with shaky-at-best credit scores. Experts said then that once the introductory rates on these subprime mortgages expired, many of the borrowers would not be able to make the monthly payments that could jump thousands of dollars overnight. Yet Wall Street, with all of its economic and financial acumen, ignored the warnings. Why?
To begin with, the business press did little to shine light on the impending mess. Rather, there were countless articles written about the strong housing market that led many investors to continue to pour money into real estate. We should have immediately been skeptical of the market "analysis" because it often was delivered by a real estate agent, an executive from a large home builder or a banker from a mortgage provider. What would you expect them to say? Their business, commissions and year-end bonuses rely on a strong real-estate market. It's akin to walking into an auto tire retailer and asking, "Do I need new tires?"
Media coverage notwithstanding, surely the professional risk managers at the financial firms would have heeded some of the economists' warnings (some from as early as January 2006) or analyzed some of the data on subprime defaults. At the very least, computerized risk models would have red flagged these investments, especially as CDOs became a larger percentage of a firm's overall risk exposure (the same way a model will send a warning that a portfolio is overweight in a particular stock).
Apparently, the managers didn't heed the warnings. Or if they did, they didn't properly weight the data, which showed that certain CDOs are extremely risky. And without giving the computerized models all of the data (not just the overly optimistic data), the models could not provide an objective risk analysis. It's the old computer axiom: garbage in equals garbage out. Without considering all of the data and warnings surrounding the CDOs (including broader economic fundamentals), the models produced garbage analysis. Unfortunately, investors will be the ones left cleaning up the subprime market's trash.
Greg MacSweeney is editorial director of InformationWeek Financial Services, whose brands include Wall Street & Technology, Bank Systems & Technology, Advanced Trading, and Insurance & Technology. View Full Bio