Email | Print    Type Size  -  +

Putting lipstick on a pig

Wall Street suffered from the illusion that it could make beautiful bonds out of piles of dubious mortgages.

By Elizabeth Spiers, contributor
Last Updated: September 14, 2008: 6:04 AM EDT

(Fortune Magazine) -- If nothing else, we've learned recently that if you put lipstick on a pig, it's still a pig. Presumably that has always been true - unless of course the pig in question was a subprime mortgage derivative, circa 2006. Then it was quite possibly a "runaway bargain," a "great time to buy," or an "opportunity in a market that's only going to go up."

Still a pig, you say? Well, how is it that no one noticed the legions of bankers, ratings agencies, and real estate professionals bearing lipstick?

Treasury Secretary Hank Paulson has engineered a rescue of Fannie (FNM, Fortune 500) and Freddie (FRE, Fortune 500), but the markets are haunted by the specter of two more big institutions - Lehman Brothers (LEH, Fortune 500) and Washington Mutual (WM, Fortune 500) - on the brink.

The fate of Lehman may soon be decided though, with recent reports suggesting some sort of deal to rescue Lehman could be announced this weekend.

How did this all happen? One answer is that Wall Street, the ratings agencies, and regulators were blinded by the science of securitization - bundling ordinary debt like credit card balances, car loans, and mortgages into vast pools, then issuing bonds backed by those pools. It was a gigantic money machine for Wall Street, but it created a system that was unprecedented in its complexity and opacity.

You might have expected ratings agencies to see the problem, but instead they became part of it. Complex securities are often priced from models that assume, in what may be the apogee of wishful economic thinking, that the underlying assets will behave exactly as they have historically. That has always been a weakness of model-based valuation, but it's particularly problematic when the securities are new and untested.

As for the Wall Street bankers who should have known better, they were mesmerized by the beauty of their creations. They forgot that those sophisticated securities were built from millions of mortgages that required someone to make payments every month. And in the real world, not the mathematical one, a lot of those loans were made to people who never had any plausible chance of repaying them. When the complexity of a security (lipstick, anyone?) has the effect of decoupling its value from that of the underlying asset, it can be very difficult to know what that security is truly worth. When no one knows what anything is worth anymore, it's easy to inflate an asset bubble.

And when it's easy to inflate an asset bubble, someone inevitably will, because all the players have incentives to do so. The way people are paid on Wall Street encourages them to pursue immediate returns at the expense of longer-term stability. Prudent managers might store capital in boom times to deal with the inevitable downturn. But given the ethos of returns-no-matter-what, available capital is capital that will be put to work. In the words of former Citigroup CEO Chuck Prince, "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing." Well, nobody's dancing anymore.  To top of page

Company Price Change % Change
Yahoo! Inc 40.93 -1.16 -2.74%
Microsoft Corp 47.52 0.84 1.80%
Bank of America Corp... 16.95 -0.09 -0.53%
Oracle Corp 39.80 -1.75 -4.21%
Facebook Inc 77.91 0.91 1.18%
Data as of 4:04pm ET
Index Last Change % Change
Dow 17,279.74 13.75 0.08%
Nasdaq 4,579.79 -13.64 -0.30%
S&P 500 2,010.40 -0.96 -0.05%
Treasuries 2.59 -0.04 -1.60%
Data as of 6:08pm ET
More Galleries
2015 Mustang's asphalt-peeling power goes modern The new Ford Mustang has been upgraded and updated to compete globally - but never fear, it's still a monster. More
15 top executives with $1 salaries Some CEOs and founders agree to salaries of just $1 a year. But once goodies like bonuses and stock options are added in, some of those executives end up taking home many millions of dollars a year. More
Mercedes SL65 AMG: 621 horses of topless power Turn heads as you blow by traffic in this roadster convertible from Mercedes. More
Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.