Monday, January 28, 2008

The Subprime Mortgage Scandal:
Regaining the Public Trust

The subprime mortgage fiasco has caused a great deal of pain … to mortgage lenders that retained the credit risk … borrowers who are losing their homes … retail and institutional investors who hold mortgage-backed securities … and the rating agencies that seriously overvalued the risky instruments.

This is certainly not the first time that a financial bubble has burst, but one has to look hard to find a time when so many financial firms lost as much as they did last year (as of January 25, 2008, an estimated $130 billion). It wasn’t just “loose lending” that was the problem. Because of the complexity of the securities themselves — each representing thousands of loans, with varying degrees of risk — even sophisticated institutions, like Morgan Stanley, had problems valuing their holdings.

According to a really incisive piece by Gretchen Morgenson in Sunday’s New York Times, the Federal Reserve is doing all it can to calm the financial markets but, as Morgenson writes, “For all its power, the Fed cannot change this troubling fact: trust in much of the financial system — banks, brokerage houses, ratings agencies, bond insurers, regulators — has been severely damaged by the subprime mortgage crisis. And that damage cannot be reversed with a quick cut in interest rates.”

“The Fed cannot turn a bad mortgage loan into a good one,” says Morgenson. “And it may not be able to convince investors that their money is safe in institutions whose risk management was so lax that their shareholders have absorbed billions in losses.”

Is there any way for financial institutions to restore the trust they’ve lost?

Economist Henry Kaufman thinks so. He recommends that the Federal Reserve and other supervisory authorities do something about “removing the opaqueness and setting new ground rules for financial disclosure.” He wants to hear “a call from Congress for an investigation where it will ask the Federal Reserve, the Securities and Exchange Commission and federal and state banking regulators, ‘What did you miss and why did you miss it?’”

Morgenson adds, “Greater disclosure of the risks in these complex securities and the institutions that hold them is in order. And investors must be confident that the values assigned to these holdings reflect market reality.”

I’d go one step further.

I’d say that transparency is also a key responsibility of the chief executives of all of those institutions that failed their stakeholders. They need to identify and disclose the vulnerabilities of their processes and systems, expose them to the light of day and clearly communicate how they are being fixed.

Technorati Tags: trust, subprime mortgage crisis, Federal Reserve, Gretchen Morgenson, Henry Kaufman, financial institutions, securities, business, communications, public relations


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