Key players should absorb subprime lessons

One of the keys to success in any endeavor is learning from experience.
MAR 03, 2008
By  MFXFeeder
One of the keys to success in any endeavor is learning from experience. The government, investment and mortgage bankers, ratings agencies and investors all have much to ponder and learn as a result of the subprime-mortgage fiasco. Congress should take no action until one of its research arms, perhaps the Congressional Budget Office, has studied the issues and determined where the flaws are. If the regulations were poorly implemented, the solution is to pressure regulators, e.g., the Office of the Comptroller of the Currency or the Securities and Exchange Commission, etc., for better enforcement. If there are gaps in the regulations, they should be filled by new, tighter regulations. But if the problems are the result of new developments in the financial markets, they will be more difficult to solve. Any legislative solution will have to be carefully crafted so as to protect investors while not unnecessarily constraining financial innovation. Congress seems to be learning about the high cost of ill-conceived action as a result of its too-hasty passage of the Sarbanes-Oxley Act. Since its enactment in 2002, SOX appears to have weakened U.S. capital markets vis-à-vis the foreign competition and imposed unforeseen costs on American companies. Now, in the wake of the subprime-mortgage collapse and the economic problems that have followed, Congress has held a few hearings but hasn't rushed to pass legislation. Congress should consider the possible negative consequences of any new regulation, such as a requirement that all mortgage originators hold on to 5% of each mortgage. Such a requirement would be intended to ensure that mortgage originators maintained some exposure to the mortgage and therefore exercised more caution in their mortgage underwriting. This would certainly reduce the likelihood of future subprime disasters, as few subprime mortgages would be issued. However, such a requirement also likely would reduce the number of mortgages each institution could offer, and hence reduce the availability of mortgages overall, which could possibly increase mortgage interest rates. Congress would have to evaluate that trade-off. A key lesson for investment and mortgage bankers is humility. Many of these bankers thought that their quantitatively based risk control programs were flawless and would protect them from disaster. But these models were based on historic data. History often does repeat itself, but not exactly, and models have difficulty recognizing the differences. The result was huge write-downs for these firms. The lessons for the ratings agencies are more skepticism and more-in-depth analysis of the securities they are paid to rate. Too often, the agencies relied on the analyses of the investment bankers who were packaging the securities. In addition, the ratings agencies will have to accept lower profit margins because they will have to pay more to attract high-quality graduates from top schools. Their analysts will have to be equal to those hired by the investment bankers. Finally, investors and their financial advisers will have to treat with more skepticism the exotic offerings and claims of Wall Street salesmen. They will also have to remind themselves that risk and return are joined at the hip. Where higher return goes, so goes higher risk.

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