Subprime Mortgages & Risk Sensitivity Explained

"It is sad how little we have learned about the market’s frequent insensitivity to risk."

That's the concluding sentence of a short essay by Avinash Persaud that helps to explain why sub-prime mortgages, which account for less than 1% of the world's debt, caused this whole mess:

The pursuit of “risk sensitivity” led to a re-organisation of bank assets away from lending on the basis of the banker’s private views about the borrower - regulators considered this hard to quantify and a little suspect – towards lending on the basis of an external credit rating. The higher the rating, the lower the capital banks had to set aside against the loan. Regulators saw this as not only risk-sensitive but transparent and quantifiable. Banking by numbers was oh so modern.

Regulators always seem to be pushing towards greater transparency in all things. Transparency is, in itself, a good thing - no question. But I find the total and complete focus on transparency to place too much faith in the ability and/or willingness of market actors to understand what these indicators reveal (or don't) and to alter their behaviour accordingly. In this case, the article concludes that the push for quantifiable risk actually obscured the nature of the risk within debt instruments.

For the policy discussion at hand, this is part of a larger point on regulation. Last night we heard Senator Obama blaming "deregulation" for the current crisis, and it's reasonable to expect the regulatory hand to come down a lot more heavily in the months to come. So be it. But preventing future bubbles in non-mortgage-related markets will require better regulation, not simply more of it. This is, of course, easier said than done - but I think it's time to take a good hard look at the market's historical record in sensitivity to risk.