Saturday, August 25, 2007

Sub-prime Time


Here we go again.

I’ve been in this business long enough to call to mind several big financial scandals. Not Enron and WorldCom types—ultimately, those were, to my way of thinking, pretty isolated cases, albeit driven by the motivation that seems to drive all financial scandals: greed and hubris.

However, over the past couple of weeks, retirement savings balances have been buffeted about by concerns about liquidity in the market, triggered by issues regarding institutions that have (apparently) loaned money to people that were based on property values that were projected to go up—when they haven’t. The problem, of course, isn’t just people being overextended on their mortgages (though that is a problem), or the firms that have allowed that situation to occur (though that is also a problem); it’s that the latter have created a whole category of investments that consist of those unraveling mortgage commitments—and lots of us have money tied up in those investments – or impacted by money tied up in those investments - whether we know it or not.

Signs of Trouble

It’s not like we couldn’t see this coming. People have been wringing their hands about the housing bubble bursting for quite some time now. Just like we did about junk bonds (before we called them “high-yield”), derivatives (before we started referring to them as “alternative” investments), and hedge funds (which are also sometimes called alternative investments, but here mainly because, IMHO, many have really been alternatives TO investing, à la betting against the market). Now, I’ll concede that the latter hasn’t imploded yet, at least not on a broad-scale, but the signs are all there, and we’ve already seen a couple “blow up.” But, as for our most recent problem, let’s be honest with ourselves—those who buy into (or take on) something called “subprime” certainly can’t plausibly say they didn’t see the potential for problems.

None of this is inherently bad, of course. Part of the beauty of our free market system lies in its ability to create new ways for innovative minds to raise capital and make money. Where we get into trouble is (a) when everybody “catches on” to the latest idea (thus drying up much or all of the opportunity), and (b) when “they” do so via “leverage”—that is, spending money they don’t have. Now, leverage, too, can be an enabling thing, but when everybody is doing it, well, sooner or later, the people who lend money always seem to want to be repaid—and, generally speaking, when the collateral that supports such investments can least afford that demand.

Not that that rationalization is likely to be of much solace to the retirement plan participants whose accounts are currently taking it on the chin, however. It’s not their fault (unless, of course, they contributed to the problem by taking out a mortgage they couldn’t afford, betting on the continued rise in house prices—just another form of borrowing money you don’t have), and yet they, as investors in and beneficiaries of the investment markets, must ride out the bad as well as the good.

The current “tumult” (we seem to be past the “crisis” stage, at least for the moment) should serve to remind us all of the dangers. You already may be hearing questions from plan sponsors and participants—about what is going on in the markets, about what has happened to their account balances—maybe even about what you recommend they should do about it all.

Questions are good. It means people are paying attention. But wouldn’t it be nice if the people who created these crises did - - - before they got to be the people who create these crisis?

- Nevin E. Adams, JD

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