Tuesday, January 22, 2008

Mortgage crisis

So there we go - it's now official - the chickens are coming home to roost.

The article in NY times "If Everyone’s Finger-Pointing, Who’s to Blame?" details a massive tangle of lawsuits that is now sweeping the mortgage industry - everybody is suing everybody else to recover a part of the massive losses.


Funnily, the people who are getting sued (brokers, bankers, insurers) have absorbed but a fraction of the money that has been lost, of course, so the potential for redress is rather slim.

7 years ago, at the end of the .com boom, the financial industry has been facing the very same question - how come there was such a massive failure to see the obvious things, by the people who were specifically charged with watching over them. The answer is still the same - underpricing the risk, that is prevalent in the U. S. today.

I have a longish analysis here: http://1-800-magic.blogspot.com/2007/12/risk-vs-reward.html

But the short story is this: execs are paid a lot if the company hits, or exceeds profit targets. They are insulated by a negative effects of a risky project by the golden parachutes. Projects that are very risky long term (like lending to unqualified people) could produce marvelous short-term results (a surge in loans -> a surge in short term revenue -> higher stock price -> lots of money from stock options).

The effect is further amplified by the fact that once one company starts doing it, others are all but required to follow suit - otherwise THEIR earnings start looking bad comparatively, the stock goes below the exercise price, and execs are paid nothing. Well, except the salary. Funnily, this reminds me of a Soviet time Russian curse "damn you to live on the salary alone" (as opposed to salary + whatever one could steal, which often was a lot more).

A quote by Upton Sinclair - "It is difficult to get a man to understand something when his salary depends upon his not understanding it.". Funny how the history repeats itself...

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