Risks Factors
There is a section in the prospectus delivered with newly issued public securities called Risk Factors. It contains a catalog of what can go wrong. For example, in an offering of bonds to construct utilities in a newly formed subdivision, the repayment of those bonds from taxes to be raised in the future depends on a fairly rapid sale of houses in the subdivision to homeowners who will become tax payers. If that does not happen, then the tax burden for repaying the bonds will fall on the developer who holds the property. If he becomes insolvent, the tax burden will fall on his lenders who will become owners of the property. If they become insolvent then it will depend on who takes over the property which could delay the repayment and so it goes.
Financial instruments that are sold only to institutional purchasers such as banks and insurance companies do not have the same rigorous disclosure statements as public offerings under the theory that because they are sophisticated purchasers, they can do their own due diligence to determine the credit worthiness of the security in question. However known risk factors should still be disclosed.
The current situation with Bear Sterns as well as the substantial losses of other investment banking firms, puts the theory or assumption of sophistication in doubt. Clearly they did not understand the risk in the mortgage instruments they were issuing or buying. If they did understand the risk they would not have been so foolish as to traded in those instruments in the amounts they did. Intelligent people do not bet their company on a throw of the dice.
The people in the finance business are risk takers, but they are always looking for ways to manage the risk. Some of these instruments were seen as products that did manage risk. That perception was clearly misplaced and as urgent is the need to make sure our financial markets remain solvent, there is also an urgent need to find out why the analysis of risk factors on these instruments was so far from reality.
The Fed and the SEC need to set up an independent task force to do a hind sight risk analysis on these failed financial instruments, followed by a study on where the current risk management system failed. The integrity of the financial market would be enhanced as would confidence in the markets.
So far CNN reports that all the overtime put in over the weekend by the corporate lawyers and investment bankers has not calmed the markets. AP also reports the negative reaction of the Asian markets.
The Wall Street Journal in an editorial discusses the Feds failed attempt to slow the decline of the dollar by lowering the discount rate. It makes the case that the Feds actions have increased the lack of confidence in the dollar. This lack of confidence is obviously caused by questions raised by risks that remain in the US credit markets. It is clearly time to work on restoring the integrity of the market place with the type of study I have suggested. With those disclosures will come mechanisms that will permit the market to take into account the risks that remain in the financial institution and what needs to be done to manage that risk.
Financial instruments that are sold only to institutional purchasers such as banks and insurance companies do not have the same rigorous disclosure statements as public offerings under the theory that because they are sophisticated purchasers, they can do their own due diligence to determine the credit worthiness of the security in question. However known risk factors should still be disclosed.
The current situation with Bear Sterns as well as the substantial losses of other investment banking firms, puts the theory or assumption of sophistication in doubt. Clearly they did not understand the risk in the mortgage instruments they were issuing or buying. If they did understand the risk they would not have been so foolish as to traded in those instruments in the amounts they did. Intelligent people do not bet their company on a throw of the dice.
The people in the finance business are risk takers, but they are always looking for ways to manage the risk. Some of these instruments were seen as products that did manage risk. That perception was clearly misplaced and as urgent is the need to make sure our financial markets remain solvent, there is also an urgent need to find out why the analysis of risk factors on these instruments was so far from reality.
The Fed and the SEC need to set up an independent task force to do a hind sight risk analysis on these failed financial instruments, followed by a study on where the current risk management system failed. The integrity of the financial market would be enhanced as would confidence in the markets.
So far CNN reports that all the overtime put in over the weekend by the corporate lawyers and investment bankers has not calmed the markets. AP also reports the negative reaction of the Asian markets.
The Wall Street Journal in an editorial discusses the Feds failed attempt to slow the decline of the dollar by lowering the discount rate. It makes the case that the Feds actions have increased the lack of confidence in the dollar. This lack of confidence is obviously caused by questions raised by risks that remain in the US credit markets. It is clearly time to work on restoring the integrity of the market place with the type of study I have suggested. With those disclosures will come mechanisms that will permit the market to take into account the risks that remain in the financial institution and what needs to be done to manage that risk.
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