There are a number of things one can say caused this recent meltdown in the financial markets. Make no mistake about it. This is a meltdown. I might even call it Armageddon. No one could have anticipated that in a three month period, Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch and AIG would call go up in smoke. And, the carnage is not yet over (e.g. Washington Mutual, et al). So what could possibly have caused this? It can be summed up in two words: asymmetric risk.

Asymmetric risk can be technically defined as an environment where the gain one accrues when the underlying asset moves in one direction is significantly different from the loss when the underlying asset moves in the opposite direction. In laymen’s terms, this means that when things are good, I win; when things are bad, I don’t lose.

This reflects the paradigm in both the housing market and Wall Street over the past decade. Let’s look at the housing market first. The asymmetric risk in the housing market is resident in a concept called securitization. Securitization is commonly defined as the pooling of assets and the issuance of securities to finance the carrying of the pooled assets. What does that mean? In the case of mortgages, it means that if a mortgage broker originates 10 mortgages $100,000 each for a local bank, the bank can then pool those mortgages together for a combined value of $1,000,000 (10 x $100,000) and then sell that package to investors, either large institutions or individuals. That $1 million pool would be broken down into smaller fixed income securities (“mortgage-backed securities”) and sold in smaller increments, perhaps $20 per security. The bank could then sell 50,000 of these $20 securities to get the entire $1 million of mortgages off their books. Got it? Good. So what is the problem with this? Why is the risk asymmetric? Well let’s say I am the local bank originating the mortgages. These banks typically charge you all kinds of fees during the mortgage origination process (e.g. origination fees, escrow fees, preparation fees, appraisal fees, etc.) If the bank knows that ultimately, they are going to sell the underlying mortgage to someone else, they ultimately don’t have any risk in how the mortgage actually performs. If the home owner defaults (i.e. doesn’t pay the interest & principle), the bank doesn’t care, because they don’t own the mortgage anymore, the mortgage-backed security holders own it. That being the case, it is then in the banks’ interest to originate and sell as many mortgages and collect as much fees as they can. What happens is that they start cutting corners. They start giving bigger mortgages to people than they can afford because they want more fees. They start giving mortgages to people with bad credit because they ultimately have no risk in whether or not that person pays the mortgage. You see the risk is asymmetric. The more mortgages the bank originates the more money they make. If the loans perform badly, they don’t lose, because they don’t own the mortgage.

Now you can see how asymmetric risk helped cause this mortgage crisis. What about Wall Street? There are numerous examples of asymmetric risk on Wall Street. Wall Street firms are the ones that actually execute the securitization process and they take big fees also. In that case, the asymmetric risk is very similar to what is described above. However, the most blatant form of asymmetric risk on Wall Street is the compensation structure. A typical investment banker, salesman or trader on Wall Street makes very little in base salary (maybe not to the rest of us -- $150,000 - $300,000). They get most of their compensation in the form of a year end performance bonus. These bonuses range from a few hundred thousand to tens of millions. The asymmetry of the risk here is that most of them get paid in cash at the end of the year while the performance of the work they do is generally not know for months and in several cases years. What happened in the current paradigm is that Wall Street guys had an incentive to create these sophisticated securities that they could sell into the market. They sold billions of dollars of these securities for which they collected hundreds of millions in fees which were paid out in bonuses. Today, we are finding out that those securities were bogus. They are only worth fractions of what they were originally sold for. The problem is that the bankers have already been paid and bought their multi-million apartments, homes in the Hamptons, and BMWs. Now who is left holding the bag? The shareholders of their companies and the U.S. taxpayers (we will need to discuss that in another post).

So what is the answer? Make the risk more symmetric. In the instance of the housing market, there either needs to be very very strict underwriting policies that mortgage brokers cannot stray from if they want to sell to Fannie Mae and Freddie Mac and / or the banks that securitize should be required to hold a bigger piece of the securitization on their books (often called the B-piece).

In the case of Wall Street compensation, these guys should get a larger percentage of their bonus in equity, not cash. Of course, Bear Stearns was renown for paying their people in stock, so when the company folded earlier this summer, people lost a great deal of their personal wealth. Although that is unfortunate, that is the way it should be, because that wealth was not real in the first place. It was generated through fees on bogus securities. It was a hard lesson for Bear Stearns employees, but a good one for the rest of the street moving forward. In fact, going forward, all banks should require even a larger portion of the bonuses to be paid in restricted stock that cannot be sold for several years.