Thursday, February 26, 2009

Foreclosure Loophole

CNBC has a good video related to our economic meltdown: Foreclosure Loophole. The theme of the video is that the mortgages have been securitized, tweaked, shuffled, and reshuffled to the point the banks holding the securitied can no longer "prove" that they even own a particular loan.

The significance of this video, from the perspective of our economic system, is that there are limits to the dogmatic assertion that markets need flexibility to promote economic growth. Having some flexibility in marketing mortgages can be beneficial. But here the securitization marketers sliced and diced the mortgages (for the purpose of generating transactions fees) to the point that a "concrete" asset morphed into an abstract security that required computer modeling to establish its value. Unfortunately, history has now demonstrated that the computer models were flawed. Beyond the flawed computer model, these securities were recharacterized to the point that the paper trail became shredded. Due to the lack of an adequate paper trail, the security holders now find themselves unable to prove that they even own the underlying mortgages that make up their securities!

Furthermore, one needs to question why these securities were even being created. It seems that they were being created as a means of selling the same asset (mortgage) over, over, and over again to generate commissions. Generating transaction fees does NOT generate wealth for the economy and is equivalent to churning, which is an abusive business tactic.

To make matters worse, the risk managers charged with insuring these security instruments (AIG as an example) failed to undertake due diligence in writing the insurance. So, as these security instruments failed, the insurance wasn't there to cover the losses.

The meltdown of our financial system is a clear market failure resulting from the willful purposeful actions of some individuals without any regard to the potential damage to society that could result from their actions. Our financial system is supposedly built on trust. If the financial system does not want regulation, don't abuse the trust that society expects of you.

Yes innovation is good. But it is atrocious when innovation is misused to convert something that is concrete (such as a home mortgage) into an abstract unfathomable security. To resurect an old phrase this is "Voodoo Economics".

Update 2/27/2009: As luck would have it, I ran across the following in the March 2009 issue of Newsmax. Newsmax writes: "Beware of financial innovation. Why? Because most of it is designed to enrich the innovtors, not the investors. Just think of the multiple layers of fees, to the salespeople, servicers, banks, underwriters, and brokers selling mortgage-backed debt obligations. These new products (credit default swaps are another example) enriched their marketers during 2005-2007, only to impoverish the clients who held them in 2008."

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