Wednesday, February 11, 2009

Mistrust (2)

During the last decade these practices broke down and were replaced by blind trust. Many financial innovations widened the gap between lenders and borrowers to the extent the final lender knew nothing about the trustworthiness of the borrower. They had no reason for not mistrusting them, but they chose to trust.

  • Mortgage brokers stopped scrutinising potential borrows and started trusting anyone who asked for a housing loan.
  • Credit ratings agencies stopped scrutinising financial institutions and starting taking payments for helping them to cook up their crazy financial concoctions.
  • Banks lent money without knowing whether the borrower was creditable and with no certainty about the collateral.
  • Hedge funds and pension funds purchased securitised mortgages without any idea whether they would be repaid or not. The just trusted the investment banks that issued the securities.
  • Many of these securities have proved to be unworthy of trust, which is just what you expect.
The credit crisis emerged because mistrust disappeared and was replaced with blind faith and stupidity.

4 comments:

Steve Scott said...

Ron,

One of the saddest results of this blind trust (a collective trust) is that there are now many very trustworthy people who have had the rug pulled out from under them and will be labeled untrustworthy.

c141nav said...

I've read lots about the mortgage meltdown. Banks, credit ratings agencies, and so much more.

But I still haven't seen any mention of Private Mortgage Insurance (PMI).

Mortgage companies were requiring PMI to everyone who had less than 80% loan to value. Even if they didn't really qualify (less income than stated) for a loan, they did pay for PMI.

If I ran a credit ratings agency and saw that the borrower had PMI, then I probably would have rated the mortgage high. Cause I knew if the borrower defaulted, the PMI would pick up the default.

Shalom,

RonMcK said...

c141nav. The problem is that PMI does not eliminate risk, it just shifts it. The medium likelihood low impact risk of home owners defaulting is replaced with a low likelihood high impact risk of the insurance company defaulting. In the current situation, the number of mortgage defaults has been so great that the insurance companies have not been able to cover the risk.

The credit rating agencies trusted the insurance companies to deal with all defaults. They did not allow sufficiently for the possibility that the insurance company might default.

Insurance is a method for sharing risk. It protects individuals from events that happen rarely. If one person in a community has their house burnt down, the rest of the group of people who are insured share the cost of replacing their house. If most houses that are insured by a company are burnt down, then the insurance company will fail. Reinsurance is used to share the risk with companies in other countries. If houses were burnt down all round the world, the entire insurance system would collapse. Insurance cannot protect us from a universal disaster. It can only protect us from severe incidents that strike sporadically.

In the current situation, such a large proportion of mortgages have defaulted than the insurance companies models predicted. Therefore their reserves are insufficient to carry the risk.

You would need to mistrust the insurance companies a little.

c141nav said...

Yes, but none of the insurance companies PAID ANYTHING. Of course they would have eventually gone out of business (or re-priced their products).

To continue in business, command premiums from new and current clients, and NEVER pay what they contractually obligated themselves to pay is the ultimate mistrust.

Shalom,
Bill