Mortgage-Backed Securities: Wall Street Attempts To Create An Entity With No Consequences

Banks can’t stop lending forever, that’s how they make money. They take your money, pay you an interest rate on it, then lend it out at higher rates. They cannot axe out the latter part of the equation indefinitely if they wish to remain in business over the long run. Right now banks are just waiting out the storm just as we are to see which institutions are going to survive so they know which counterparties they can do business with confidently. Risk aversion is extremely high across the entire landscape of our financial ecosystem right now. No one wants to take on any risk whatsoever.

Equities known as the best asset class to own over the long run are viewed as extremely risky, real estate is still working off excesses and prices have yet to find an official bottom, and treasury bonds the least risky asset of all are paying out yields at multi-decade lows. However the aggregate effect of extreme risk aversion will prove to be a good thing over the long run, as over this period of time where the financial system is adjusting from one of very high risk tolerance to one of very low risk tolerance, those parties who have based their models on taking on high amounts of risk will inevitably cease to exist as risk-taking counterparties pull capital at very high velocities. Those models predicated on demand for risky assets will fall by the wayside while those models less reliant on the returns of high risk assets will be just fine.

It’s funny how easily we forget that risky assets paying high yields do carry RISK. Did Wall Street just completely forget about the idea of risk when investing in subprime mortgages. Say it with me “SUB-PRIME”…..NOT PRIME……NOT HIGH QUALITY….LOW QUALITY…..HIGH YIELD……HIGH RISK! These people were not idiots, they’ve been playing this game for decades knowing that anytime you have anything that pays a higher than average yield on an investment, it means without doubt that you are taking on additional risk. That is why you are being paid a higher than average return to ASSUME THAT RISK! So the first mistake made by Wall Street - taking on higher risk assets without some sort of hedge or idea that these risky assets might in fact prove to be risky assets and lead to higher than average losses. Where was this in the game plan? i cant find it anywhere; it’s like going into battle without any plan for possible missteps, miscalculations or even outright losing

Now mistake #2, and this is even bigger than mistake #1 - LEVERAGING HIGH RISK ASSETS. How on earth can global institutions rationalize leveraging assets which payout high yields and are known to carry higher than average risk without any sort of assumption that this plan (now carrying even higher risk due to leverage!) may in fact not work as planned?? seriously I can’t figure it out. The only explanation I can think of is the idea of herd or mob mentality. Institutions looked around and saw every institution across the globe taking on these high yield high risk assets and said to themselves, look we know there’s risk here, but first of all we can’t just sit around while our competitors pull in higher than average returns, we’ll look like losers, we need to compete.

Second of all, if these assets don’t work out, and all of our competitors are holding them as well, well let’s face it, the whole system cant come crumbling down. Can it? No, we hope not. No way the Fed will save. They have to, they no choice. This was the backstop! This is the idea of mob mentality. You no longer become a single individual but rather one small part of something much larger which allows individuals to take on actions without risk of individual failure knowing that in the end any sort of consequence will be divided out between a host of individuals possibly equating to consequences less than that of the consequence of a single individual action.

And moreover, if the entity accumulates enough individual participation to become larger in size and in power than that of the overseer of the system, then there becomes the possibility that the entity cannot be stopped and/or that there remains no FATHOMABLE OR REALISTIC consequence to any action carried out by the entity, ie TOO BIG TO FAIL.

We’ve heard about this idea over and over over the past several months. Too big to fail. What does that mean? It means that when an entity becomes large enough (so large that it becomes necessary for the survival of an entity even greater than the entity itself), then the overseer of the system shifts from dealing out consequences to any negative action carried out by the entity, to one of trying to preserve the entity for fear of causing the destruction of the entity even larger than that. The overseer is forced into a position where the dealing out of consequences creates even larger consequences not only for overseer but for the larger entity that the overseer hopes to preserve.

This is what Wall Street knew and hoped for by taking on these risky loans and leveraging them, that in the end, it would become large enough that no possible consequence could present itself without creating even larger consequences for an entity even larger than itself.

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