Saturday, October 25, 2008 Batuhan: In the eye of the storm (Part 5) By Allan S.B. Batuhan Foreign Exchange
AN ASSET was born. Oh, yes, indeed, a new financial instrument had been brought out into the big, wide financial world. It was called the mortgage-backed security.
A financial instrument backed by an obligation to pay behind it is not a new thing. Paper money itself is an asset- backed security in that the holder used to have recourse to gold deposits held by the government issuing the currency. Although this is not quite the way it is anymore, still the fact that money has some sense of “value” behind it is what the concept of an asset-backed security is all about.
Assets like money have a relative sense of value depending on how secure people feel about holding them. The term “hard currency” is descriptive enough—this means that the money is perceived to be safe, because the issuer of that money is a reliable country—as in money issued by the United Kingdom is way “harder” than that from the government of Venezuela.
The same logic applied to the mortgage-backed security as well.
That the mortgages being securitized came from the United States made the assets quite desirable, in the same way that dollars are preferred the world over as a safe haven investment. The same thinking applied, namely that obligations created in the world’s biggest economy cannot conceivably be risky.
The fact that the primary obligations (mortgages in the United States) were “wrapped” in the additional security of the issuer (large American banks) lent the asset even more credence, in much the same way that a diamond from De Beers would be worth more than the exact same diamond bought from a dealer in a shop in Hong Kong.
Of course, we know now that the whole premise was wrong all along.
Mortgages originated in the United States do default. Likewise, the solid financial institutions which securitized and sold the mortgages to investors around the world were not unsinkable. All it took was the opportunity for the right set of conditions to come together, to give rise to the financial markets’ equivalent of The Perfect Storm.
Like physical storms, financial ones also give out warning signs well in advance of their actual occurrence. It is not as if all is well one day, and all hell breaks loose the next. Before we got into the mess we are in today, there were already certain manifestations of the future problem that was about to occur.
Precisely who caused the meltdown in the first place, or perhaps more appropriately, what precipitated the crisis to happen is not easy to pinpoint to a single person or a single cause. But there are a number of co-conspirators to the crime whose involvement made the mess possible.
Over the last few installments, we have attempted to introduce some of the major causes, and how each of them in their own way aggravated the situation. Now it’s time to put them all together to see how they made the current financial disaster come to being.
As we have already made clear, the introduction and subsequent boom in the popularity of the mortgage-backed security is perhaps one of the most significant. As safe investments went, investors viewed them as almost failsafe, ignoring even the most commonsensical warning to not put all their eggs in one basket, so to speak.
