The Sub Prime Crisis: Dispersed risk becomes dispersed mistrust

(Ref: The Economist, dt. 18 August)

Securitization has been one of the major financial innovations of modern times. Securitization has helped banks in the past two decades to repackage mortgage loans, convert them into liquid instruments and sell them in tranches with varying degrees of risk to other market participants. They in turn have sold securities to other investors. This way, the risk has spread across the system. But this seems to have created more problems than solved them.

As the Economist (August 18, 2007) mentions, the dispersal of risk should logically lead to many players holding small losses. “But the swings in almost all financial markets this month have made dispersed risk suddenly morph into dispersed mistrust.”

The magazine quotes Avinash Persaud, a respected financial analyst: “Securitisation has meant that credit risks have moved from knowledgeable long term hands to fast hands, where the principal risk management strategy is to sell before the prices fall more.”

Let me give my own take now. Think of a spicy Indian dish. If big chilly pieces are seen floating, one can easily pick them out and avoid getting into trouble. If on the other hand, we have cut them into small pieces or ground them nicely, and the dish becomes “too hot,” people are going to consume little of that and whole dish may have to be discarded. A very crude anology but that may well sum up the situation today.