Saturday, September 29, 2007

Financial Risk With Innovative Investments - Buyer Beware

For many years, the majority of financial risk for lending money was owned by banks and the government. Loans to businesses and individuals were made by banks, and it was in their best interest to find good customers who were able to make payments. Individual depositors at banks were relatively well protected through the government via FDIC insurance.

Recently, the risk has been shifting from banks and the government to individuals, via innovative financial instruments. This has been most evident in the sub prime mortgage crisis. It appears that mortgage brokers are now "investment bankers" for individual investors by packaging loans into collateralized debt obligations (CDO) that are sold. If the mortgagee defaults on the loan, the investors in the CDOs will bear the brunt of the loss of payments. While CDOs were sold as "safe" investments (i.e. AAA rated bonds), recent events have shown that it was was mostly safe for those that issued them. is another example of an innovative investment where risk has been transferred from banks and government to individuals. In the past, experienced bank loan officers would evaluate applicants before loaning the banks money. In transactions, many inexperienced individuals are now evaluating applicants and make loans. The early results have shown this transferal of risk hasn't been an issue. However, should there be a significant increase in defaults, lenders in will experience similar liquidity and valuation issues as the investors in CDOs.

As always, higher returns generally are not a free lunch. While CDOs and loans provide higher returns, they are also subject to a higher default rate. In boom times, the true default rate may masked by economic prosperity and appear attractively low. However, should there be a leveling out or decline in the economy, an increase in the default rates will show the unexpectedly high risk individual investors took on for these types of investments.

For more on Reflections and Musings, check back every Saturday for a new segment.

Photo Credit:, Stuart Whitmore

This is not financial advice. Please consult a professional advisor.

Copyright © 2007 Achievement Catalyst, LLC

No comments: