These are scary times. The collapse of Lehman Brothers. The emergency sales of Bear Stearns and Merrill Lynch. The struggles of AIG and Washington Mutual. The subprime mortgage crisis. While Morgan Stanley and Goldman Sachs are the few ones left standing, they are also exposed to the crisis. The big question then is how substantial their exposure is.
My dream companies back in college are now facing tough times. Hence, despite the fact that I am only minimally connected with these investment giants, I feel their pain. I'm no expert in finance as my financial background had been unfortunately eroded by my law studies. I'm just a wannabe (but hopefully future) finance person. I terribly enjoyed my finance classes back in college and I'm holding on to the hope that I would eventually find my way back to that path.
All these comparisons with the Great Depression scare me. I would like to believe that the financial market had placed sufficient security measures to prevent its repeat. But still, these are complex times involving complex transactions.
I think it all leads down to wise investment decisions. Due to the complexity of these investment strategies and securities, fundamental finance rules are often neglected and forgotten.
High returns, high risks. In the pursuit of high returns, banks and financial institutions hedge the risks. In the end, no one is willing to shoulder the high risks, forgetting that in interlocking transactions, no one can escape such risks.
For instance, these mortgage-backed securities often produce high returns as the collaterization and pooling of the assets increase their tradeability. Consequently, they should also be considered high risks. However, the financial institutions generally rely on the traditional concept that real estate is a low risk venture. More importantly, when mortgages and other assets are securitized, the risks are pooled and then passed on to another entity. As the risks are passed, there is less incentive for the originator to determine the creditworthiness of the borrower. The mortgages and the other assets are then transformed into securities (or derivatives) and the risks of the underlying assets are then forgotten.
We can actually no longer rely on financial statements and other traditional records since valuations of these assets and securities are often the product of much
hocus pocus as the risks are no longer properly accounted for. They're not illegal
per se as loopholes do exist not only in the legal structure, but more so in the financial structure.
In the event of a collapse (like now), other inter-related transactions are then affected. You hear about the credit default swaps problem, most specifically in the case of AIG. And then it just gets harder and harder to isolate the safe securities and investments from the risky ones as everything now revolves around perception.
The only thing that we could hope is that the market would correct itself soon enough. That is the beauty of a free market. All else equal, the optimum and efficient level would be reached. Hence, unnecessary regulation and bailouts by the government should be reduced, if not eliminated. Financial institutions must account for the risks of their investment strategies, instead of allowing them to employ complex transactions to spin off the risk and then run back to the government in case of disastrous investment decisions (that threaten the entire financial market!). Lastly, my finance and economic professors often reminded us that no matter how complex the transaction is, it would never hurt to go back to the basics.
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Hmmm, I missed this kind of discussion. I've been so focused on legal discussions that this entry feels like a breath of fresh air. :)