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December 10, 2008

Finding a Transparent Solution

Brian Belardi
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Understanding the financial underpinnings of mortgage-backed securities, the investments at the center of the financial crisis, is a difficult task. The complex structure of these investments may have even obscured their inherent risk to those parties directly involved with their purchase and sale.

A December 7 New York Times article by Gretchen Morgenson chronicles the predicament of Moody’s, the credit rating agency that has fallen under scrutiny for inaccurately giving high ratings to many mortgage-backed securities, including those with questionable financial fundamentals.

The rating agencies, however, were not alone in their misjudgment. According to a recent article by Professor Trevor Harris in Ideas at Work, all parties to the transactions — including the lenders, mortgage brokers and banks, securities firms and borrowers — failed to understand the fundamentals of these investments.

According to Harris, “[They] were making a bet on constantly rising home prices, while disregarding the real people and real homes on top of which these products were precariously built. Much like a Ponzi scheme, everyone lent to everyone else, creating a bubble and then compounding it. Returns could only continue while new money kept flowing into the system. When the money stopped, the whole system started unraveling.”

Harris suggests that by bringing transparency into the underlying fundamentals and risk characteristics of a business, regulators will be able to provide a more accurate and complete assessment of the related fundamentals and risks.

For a more detailed look at how the fundamentals of mortgage-related investments were neglected and what can be done to prevent this from happening again, see Harris’s article, “Back to Basics,” in Ideas at Work.