The Problems on Wall Street

Wall Street is where Mortgages are pooled, securities are created and then sold to investors. Basically it’s the marketplace. This is a world of alphabet soup. RMBS, CDOs, SIVs, etc. is the language of this market place. For the rest of us they are referring to residential mortgage backed securities, collateralized debt obligations and structured investment vehicles.

The brokerage houses role in the mortgage market is to take a pool of mortgages and create securities with various yields. The best way to gain an understanding of what they do is with an example. Let’s say we have a pool of mortgages with an average interest rate of 8%. Not all mortgage are going to perform as expected. A series of tranches, securities yielding a specific rate of return, are created. For our example we use 3, one yielding 6%, one yielding 8% and one yielding 10%. As the borrowers make mortgage payments the investors who purchased the securities yielding 6% are paid first. Once all those obligations are met then the next group of investors, those expecting 8%, is paid. Only after the obligation to these securities are satisfied can the investors who purchased the securities yielding 10% see any money. As this example illustrates, the higher the yield, the higher the risk of the investment.

These securities can then be pooled with other securities, creating new tranches that are also sold. Mortgage backed securities can be pooled with credit card receivables, personal loans, car loans, etc. The brokerage houses of Wall Street create complicated investment vehicles that are designed to meet the goals of all the various investors. This system is totally dependant on the ability to accurately predict the performance of the underlying mortgages and promissory notes. The current problem in the mortgage market today is because the predictions were very wrong.

How could all these experts be so wrong? There are several reasons, all of which have contributed to the problem. We’ll probably never know for sure the magnitude each reason played but we do know the results, today’s mortgage meltdown.

The first reason is both the investor as well as Wall Street depend on the rating agencies to analyse the risk of each security offered. As discussed earlier, the rating agencies miscalculated the risk of the securities. The Wall Street firms, as well as all investors, use the rating of a security as a starting point. They will then do their own calculations to determine risk. It’s obvious now that those calculations were no better that those performed by the rating agencies.

The next issue is the magnitude of the complication of the securities being offered. It’s being discovered only now that the securities that have been offered are so intertwined with each other that, every missed mortgage payments is magnified a hundred times over. It seems that the people who designed the securities didn’t have a full understanding of this. To make matters worse, the investors that were purchasing these securities also had no clue about all these inter-dependencies.

This brings us to the most important question. Were the people involved in this market aware of these shortcomings and just ignored them? Millions of dollars were made, both by the company as well as the individuals working in the industry. Did the money they were making blind them all or were they ignorant to what they were doing?

Whatever the reason, it is clear that Wall Street is not living up to its obligation to maintain a marketplace where investors can depend on the data provided. Investors need to be able to make informed decisions. Wall Street can only function if it has the confidence of the investment community. We live in a global economy; Wall Street isn’t the only marketplace for investors. Once investors lose faith in Wall Street, they will simply invest in other markets. Should this occur, we will no longer be a leader in world economics; we will become a second rate country. The current state of our economy isn’t as strong as it should be; what state of economic health will we be in, when investors begin to put their money elsewhere?

Wall Street needs to regain its international creditability before we can hope to re-ignite our economy. The mortgage market is only one piece of a large security market; yet when it went bad, the effects were and stil are, being felt around the world. Imagine what will happen if another component of the market was to go bad.