There are many factors in the meltdown in subprime mortgages and the recent stock market slide, ranging from the actions of the Federal Reserve over the last ten years to the complexities of bond rating agencies to the intricacies of financial engineering. Like most booms and busts, however, this one revealed a number of basic principles that were overlooked when times were good.

Mismatch – When loans are readily available it is tempting to “borrow short” (take out short-term loans) and “lend long” (use the proceeds to make long-term loans or illiquid investments). Unfortunately this requires repeatedly borrowing short-term money, and when the terms of that borrowing turn unfavorable, or it becomes impossible to borrow at all, assets must be sold in a declining market and the house of cards collapses. This trap caught homeowners with adjustable -rate mortgages as well as sophisticated lenders such as the French bank PNB Paribas. The safer strategy, which may forego some short-term gains, is to borrow under terms that match the use of the loan proceeds.

What Are the Odds – Many of the players caught in this mismatch would have readily acknowledged the risks of the borrowing stream being shut off, but they simply concluded that the likelihood of that happening was so remote that they just kept placing bigger bets and increasing the risk. (Variations of this pitfall are “it’s worse than we thought” and “this time it’s different”, both of which are symptoms of a refusal to recognize the inevitable.) Here’s a good rule of thumb: if you find yourself thinking that everything will be fine unless “x” happens, you should prepare for “x” to happen. This is the basis for all insurance, which is protection against risks we hope never come to fruition.

What a Surprise – There can be events that come out of nowhere and are completely unexpected, and this caught many “quant” money managers off guard. Quants rely on the emotionless rules of mathematics and computer models, and usually test the assumptions on which the models are based with decades of market data. Many of the models incorporate at least some of the same assumptions, increasing the impact of a scenario that falls outside of the models. In simple terms, in early August stocks that were supposed to rise fell and stocks that were supposed to fall rose. According to Lehman Brothers head quant, “events that models only predicted would happen once in 10,000 years happened every day for three days”.

Double-edged Sword – Many hedge funds and other investors are heavily leveraged, using borrowed money to increase their exposure to certain investments and markets. This dramatically increases returns while these investments are positive; for example, if half of the invested money is borrowed, the return on the investor’s own capital will be doubled. This borrowed money, however, comes with some strings attached, and when the value of the investments declines there can be a “margin call” requiring the borrower to either put up more of its own money or sell some investments. Selling investments in an already declining market often speeds the decline, creating more margin calls.

Emotions Rule – Economists and market observers have correctly noted that subprime mortgages are a fraction of the overall market and that all subprimes will not default. In other words, in a rational market the damage could likely be absorbed. Despite sophisticated analysis and sound logic, the market is driven by emotions in the short run. It does little good to insist that there is no reason for a part of the market to nearly shut down. If lenders simply decide to stop lending until the dust clears, borrowers are out of luck.

Tangled Web – An efficient market regularly punishes some if its participants; in fact, the risk of loss and actual losses are critical to regulating the flow of capital. The players who were directly involved in taking excess risks should bear the full brunt of those risks. Unfortunately, financial engineering in the form of packaged loans being sliced, sold and resold has spread that pain far beyond the original risk takers. This has created the possibility that a panic develops and spreads quickly through world markets, in which case even the most conservative and risk-averse among us will be affected.

The Federal Reserve has injected more money into the economy and has lowered the discount rate (the rate at which member banks can borrow from the Fed on a short-term basis) to restore lenders’ confidence and to prevent the tangled web from collapsing. On the other hand, the Fed has not cut the more influential Fed funds rate, which has a direct influence on all short-term interest rates, because they are still concerned about rekindling inflation. They are also concerned about the “moral hazard” of bailing out those who should rightfully incur losses, which could encourage risky behavior and lead to an even larger and more painful collapse at some point in the future. As painful as it is to see homeowners lose their homes, or to see workers in the mortgage or real estate sectors lose their jobs, the delicate balancing act is the economy’s best interests.

September 2007