There's No Such Thing as Reducing Risk...You Can Only Transfer It To Someone Else

I was speaking with a fellow economist today and he reminded me of something he has said for a long time. "You can never get rid of risk." Yes, you can transfer it to others, hedge it (which is the same thing), mitigate it with a portfolio solution etc. but SOMEBODY still is bearing it.

This is a very important basic lesson that is playing itself out in the liquidity crisis which is beginning to make itself apparent in the mortgage markets. In short, when someone takes out a home mortgage, the money is supplied by banks who then sell the mortgages, usually with a guarantee provided by the government, to the secondary market.

Investors buy securities based on these pooled mortgages which receive a return paid by the cash flow provided by principal and interest payments from the underlying mortgages. The usual risk in these instruments is that mortgage interest rates will fall and people will refinance, which is to say, pay off their mortgages suddenly by taking out another one at lower rates.

When interest rates fall and a large number of people begin to prepay or refinance their mortgages at lower rates, those who offered these mortgage backed securities become flush with cash from the refinancing but cannot invest it in instruments which pay enough to service the rates on the original securities. There are sophisticated ways to hedge these risks but the risks remain and someone loses money when this happens.

The mortgage markets also offer home mortgages to high risk borrowers (so-called sub prime mortgages) often without requiring even proof of employment. These are made attractive because they have a "known" rate of default and they are priced to the borrowers (i.e., at a higher interest rate) to cover these normal problems.

What we see happening is a large default rate occuring as the sub-prime borrowers face interest rate adjustments on their initial mortgages (often offered at teaser rates initially) and they are unable to pay them. Without the cash flow from the principal and interest payments, those holding the pooled securities based on these obligations wind up holding the bag. In the extreme (such as we are now beginning to experience), these securities cannot even be priced so holders cannot dump them to bottom-feeders who might want to assume the risk at a cheap enough price.

When these securities are used as collateral to acquire debt and they suddenly cannot be priced, what do you suppose the lenders want? Think of the farm crisis years of the 1980's when land values (collateral) dropped dramatically and outstanding debt exceeded the value of assets. Lenders demanded an influx of cash to correct the equity problem (which started as a demand to sell some assets, like that second home or cabin at the lake) and progressed to the cannibaliszation of productive assets and then foreclosures.

With all of this trouble in the lending market and an unknown amount of default yet to come, no one wants to buy mortgage based securities. When no one wants to buy these securities, banks don't have the money to keep making mortgage loans with their own funds and hold the mortgages inhouse. Hence, mortgage lending comes to a screeching halt.

More on this to come...