slice and dice risk... this one bears watching

The sub-prime mortgage mess that has now bitten the hide of one of the original houses of the Wall Street (New York Times, June 22, 2007) bears watching. There's now a fear of a contagion. Bear Sterns, the large Wall Street bank has had to put up 3.2 billions dollars to rescue one of its troubling funds from collapse, after the creditors came knocking. There's however, a much more messier, fund which Bear holds that is likely even a larger mess, as it holds more riskier sub-prime assets.

It was a fortnight ago, that it was thought that financial risk was done away with for good. The idea is that by pooling risky assets, such as loans to people who could not afford them in the first place, loans to companies which can not afford them ever (think buy-out), into collateralized debt obligations (CDO) and turning around and selling them to a basket (or is it basket case) of investors, risk will be sliced into so many small pieces that at any one time, the amount of risk (presumably, a measurable quantity) held by any one entity would be minuscule.

This idea works in theory, but in practice, since human psychology is not quite yet separable into measurable quanta, what happens often is the exact opposite, i. e. more risk is taken on and again more risk and more and more. Consider the following: if a bank knows that it could only hold on to a mortgage, after taking fees and commissions, for only a few hours at best, before it is securitized into CDO and other instruments and sold on the market, now matter how risky, don't you think, it would take on more risk, if the object in this game is to make more fees and commissions? Of course, it would be. The goner is, of course, the fiduciary duty of a financial institution and this is what we are witnessing today.

This mess will likely get bigger before it gets smaller. Remember that the sub-prime mess began with small lenders last year, spread to home builders, and is now moving up the financial food chain.