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‘Wall Street’ risk managment and judgment compromised by blindness, madness and greed.

Posted by Adrian on November 14, 2007

Wall Street has taken huge losses from billion dollar plus write downs on collateral debt, mortgage backed securities and any other complex financial instrument’s connected with the mortgage crisis in America. Which in turn has decreased the asset value of many of the banks that invested in the mortgage market in America, to the point that the collartirised debt obligations (CDO’s) sitting in investment pools and accounts of those banks and hedge funds became a ‘toxic waste’ product that no one would touch. The blind feverish packaging of debt investments like CDO’s, that were majority backed by subprime mortgages, occurred throughout the housing boom in America over the last decade. It was in all retrospect a greed induced blindness, if by definition the theory that profit returns on CDO’s and other debt financial investments was going to be a sure thing, then something went wrong in the psychological risk management in the Wall Street firms and the big retail banks. Was it simply a greed induced frenzy on profit returns or a complete miscalculation of the overvalued mortgage bonds, or an ignorant disposition and assumption that the economy and mortgage market in America was going to continue on without risk. Or all of above.

From Fortune regarding Merrill Lynch Investments Bank, CNN money:

In February international bank HSBC suffered big losses on its subprime portfolio, sending tremors through the market. Under normal circumstances, such worries would have led to higher interest rates on subprime mortgage bonds. But these were not normal times. Instead of rising, rates on subprime mortgage bonds remained abnormally low until the summer of 2007, and in some months even dropped below 2006 levels.

What was going on? Instead of backing away from subprime paper, Merrill Lynch and other big players were gobbling all they could, because they needed it to feed their CDO’s. Their bottomless appetite for the stuff kept prices high and yields low, against all economic logic. “What we had was a perpetual-motion machine driving mortgage prices to uneconomic levels of risk vs. reward,” says Friedberg.”

This appetite for the now risky CDO’s continued with not just big investment banks like Merrill Lynch, but all of the major investment banks on Wall Street buying up and selling CDO’s to other investors – which has we know is now causing the majority of the billion dollar writedowns on Wall Street and other major financial institutions.

But, there is deeper psychological issue at play. If the risk management has faltered and the mathematical models did get it wrong as far as calculating returns on risk assets. What went wrong? The risks, in regards to the mortgage markets were obvious, especially when you consider that loans were given to extremely risky customers. The repackaging of that risk into CDO’s (as it has turned out) has been a waste of money. Can the new lore of Behavioral Economics offer some new perspective? If the world is faced with a severe economic down turn exasperated by the financial turmoil in the credit markets, which is primarily because credit was given to people that should have not received credit. We have to remember that people generally as consumers have that psychological instilled trust in authority – in which that authority (if we are talking about the selling of credit and loans) is based in the financial markets. Given that authority at times could be con job, hence the predatory lending that took place prior and during the subprime mortgage meltdown. Trust in financial institutions and their conduct as far as risk, investments and even profits has been effected, can this trust be reinstalled back into the populous? With the credit crisis not even half way through it’s severity and a more dramatic liquidity crisis widening within the finance markets. The psychological damage has already occurred, this can be seen via financial panics, the example is the English bank Northern Rock looking for emergency lending as it took a huge hit from the credit markets. This financial and psychological damage will spread wider. The confidence in the banking sector, fund managers, hedge fund markets has been damaged, a damage that will be seen in their share prices and accounts as their balance sheets will contact.

So, if after the financial crisis that is sweeping world finishes, will there be a new perspective on economics and financial markets? Like I mentioned earlier, could this perspective be the new theory of Behavioral Economics? That essentially is a new psychological based economic theory to save people from themselves. But if that is the case, that an economic theory that could direct people to make ‘right’ decisions is implicated, the ‘theory’ may need some reworking when the smartest minds in the business from hedge fund managers to the investment bankers of Wall Street; have all made some of the most horrendous mistakes in the history of the financial markets . This in turn has revealed the intellectual core of economics and finance to be completely overshadowed by it’s own flaws.

I’ll finish with the quote from Charles Mackay

“Of all the offspring of Time, Error is the most ancient, and is so old and familiar an acquaintance, that Truth, when discovered, comes upon most of us like an intruder, and meets the intruder’s welcome.”

Over time Morbius Glass blog will discuss Behavioral Economics and Free Market theory in ‘philosophy and science

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One Response to “‘Wall Street’ risk managment and judgment compromised by blindness, madness and greed.”

  1. […] is could this crisis in the banking sector be avoidable? I have briefly discussed this topic in ‘Wall Street risk management and judgment comprised by blindness, madness and greed’, and also ‘The complexity of Wall Street and the simplicity of the boom bust cycle’; […]

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