Relearning the significance of risk

A foreclosure sign hangs in front of a home for sale.

TEXT OF INTERVIEW

AMY SCOTT: Now that the holidays are just about over, many of us are taking stock of the past year -- balancing our checkbooks, making goals for 2008. For some 2007 was a boondoggle, for others a bonanza. Kind of depends on where you fell on the big market ripples. Here at Marketplace we're taking a look at the peaks and valleys of those trends with folks who know them well -- our reporters.

Steve Tripoli covers a wide range of topics for us. One that he spent countless hours researching could be best described as risky business, otherwise known as the subprime mortgage industry. Only people kinda seemed to forget about risk. Steve's here now to explain. Hey there.

STEVE TRIPOLI: Hi, Amy.

SCOTT: So how did underestimating risk get us into this whole mess?

TRIPOLI: Well you know, Amy, you might say the better word for how our system blew it, risk-wise, is that we misallocated risk. That's really the original sin here. You see, there was no risk for many mortgage brokers and people who sold risky mortgage-backed securities. And that's because they got their profits, their big commissions up-front when the mortgage and security was first sold. So they had no incentive to worry about longterm costs if these mortgages and securities went bad. So, in that case, why not just pump out super-risky products, grab your profits and let society handle the fallout? It's, you know, nice work if you can get it -- especially in the days when banks held their own loans and their own risk that was far less likely to happen.

SCOTT: Well, a lot of smart people are paid a lot of money to guard against these kinds of risks. Were they just asleep at the switch, or what happened?

TRIPOLI: Well, you're getting into the second way our system sort of misread the risk here. And that's through a failure of regulation. You know, now that this thing's blown up, it's interesting how many voices are saying we need tighter legal and regulatory controls. And we're just now starting to remember why we used to have those controls. Not only for the protection of individual consumers but to protect the whole economy. Because, as we can see, it isn't just a bunch of folks with lousy mortgages who get hurt. The economic fallout really hurts everyone. And this thing is rippling through everyone's home values now and through credit-card debt and auto loans and student loans. And we're relearning that fiascos like this can hurt most everyone, so the regulation needs to be out front.

SCOTT: Well, if we go back again to these risk-assessment experts. They were saying, right, that these mortgages and securities were safe. And wasn't the whole point of bundling these subprime loans into securities that you spread the risk around? I mean, they're the experts. What did they miss?

TRIPOLI: Well, we missed something first, Amy, and that's that history tells us that these experts themselves can often be wrong. And further that their fancy mathematical models for risk have been unreliable in the past. You know, just in the past decade we've had a Russian debt crisis, an Asian debt crisis, and a crisis centered on the finance firm -- long-term capital management. And in each of those crises fancy mathematical models blew up. So, we forgot that the risk models, themselves, remain risky and then we forgot one other risk: It'a a built-in problem with these so-called experts who are calling these new finance instruments safe. Here's how researcher Paul Vaaler at the University of Minnesota characterized that problem when we spoke recently.

PAUL VAALER: The experts, the people that we bring in to do some of this risk assessment, they're also private companies in a market looking for market share. So, guess what, maybe some of their risk assessments are going to be skewed from time to time based on their overall incentives to increase market share or to pursue some other goals.

That's a very polite way of saying those ratings agencies and others have conflicts of interest. You know, they get paid by those whose risk they rate and Congress is looking into that set-up.

SCOTT: So, Steve, what can we learn from this going forward?

TRIPOLI: Well, I just mentioned our lawmakers -- and that's a place to start. They're rethinking the extent to which we let the regulation of risk slip. We've also learned that regulators and law-enforcement people need to be on their toes, and those folks need the staffing and the will to rein in these risks that threaten the system. And we've also learned that risks like these mortgages and securities need to be priced right in the future. You know, a lot of people are saying these things were safe, and obviously they weren't. And I think we've learned that the penalties for those who abuse the system have to be priced right, too. By which I mean if finance people are going to play with fire, they should be at real risk of losing something themselves if things blow up. You know, in far too many cases this time around, the people who got us into this mess walked away not only unpunished legally but rewarded financially. And we need to think about that as a society.

SCOTT: All right. Steve Tripoli, thanks so much for joining us.

TRIPOLI: You're welcome, Amy. And Happy New Year. And maybe, hopefully, a less eventful New Year for business reporters like us.

SCOTT: Absolutely.

TRIPOLI: Take care.

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