Mark Towner's Spyglass Spots: The Price of Risk

The Price of Risk
by Dan McLaughlinSeptember 6, 2007
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Some lessons are hard to learn. Going 100 miles per hour may be exciting, but when you miss the curve, you pay the price in broken bones, bruises and large hospital bills, if you are a lucky one. Speeding is a risky undertaking. The faster you go, the higher the risk. Some people like the exhilaration so much that they are willing to take that risk. They have no choice, however, but to pay the price for their indiscretion if things don’t go as planned.
Gambling is also a risky proposition. While you may win big, there is also a chance you may lose big. If you take the risk, you must understand that it may go either way.
In the financial markets, as in most other things in life, risk is usually related to gain. Generally speaking, solid, low risk investments carry a low rate of return. As the perceived risk of loss on the investment increases, the rate of return also rises. It stands to reason that it will take a higher rate of return to induce someone to risk their assets on an investment that may not pay them back.
One of the more risky sorts of investments is sub-prime mortgages. The reason that they are sub-prime is that the borrowers have poor track records for payment. There is a substantial risk that they may default on the loan. When the value of the property securing the loan shrinks, as is happening all over today, the lender suffers a much greater exposure to loss.
Since those types of investments are quite risky, they carry a significantly higher rate of return. That means that the regular high level of income that you would get from investing in them would be somewhat offset by the losses you would take from default and from the loss of market value of the property. Anyone who agrees to invest in that type of loan also agrees to carry the burden of losses when they occur. It is only fair. They get a higher level of income when times are good, when the economy speeds along at 100 miles per hour. They must also take the lumps when the economy runs off the edge of the road.
Over the last number of years, sub-prime lending has been booming as real estate prices have skyrocketed. Monetary policy had been loosey goosey, with the Fed and other central banks keeping rates low, spurring the real estate and stock markets on to ridiculous levels. Lenders have been willing to take on more risk to get a piece of the lucrative sub-prime pie. They assumed that losses would be minimized by high property values. They have reaped the benefits of high returns while people who opted out of risk puttered along, safe and sound, with low rates of return.
Now the economy is hitting a curve in the road. We are hearing the screeching of tires as our hundred MPH friends start to spin out of control. Sub-prime loans are not looking so good. The real estate market has sunk, leaving less collateral to back up the loans. People are panicking as mega-lenders are hitting the guardrails. On one interesting televised investment program, a near delirious broker was literally screaming at the Fed, saying they have no idea how bad it is. He was demanding that they intervene to correct the problems.
Our frenzied friend was ignoring the fact that all those desperate lenders got themselves into the current situation because they chose high risk, and lots of it. That so many people joined them and created such an unstable market is a blame that can fall squarely on the back of the central banks and the incentives they offered. The problem is that now, those investors want us taxpayers and consumers to bail them out of trouble caused by their own indiscretion.
Unfortunately, the central banks have bowed to the crying, pumping in hundreds of billions of dollars of liquidity into the system to help the economy. This amounts to trying to save a drowning man by pouring water on him. Ultimately someone will have to pay for their irresponsible behavior. Once again, it will be you and me paying to save the skin of wealthy, well connected investment bankers.
The Fed created a problem that can only be solved by market adjustments. Brokers and bankers reap the income, they should also pay the severe price of those adjustments, not consumers and taxpayers.
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Dan McLaughlin is a former corporate financial officer and is currently a columnist for The Post Journal. Visit his web site at http://users.adelphia.net/~djmclaughlin/ or contact him at danmcl999@roadrunner.net.