Sophistication Meets The Sledgehammer

The see if sleek, modern financial products work, investors body-slam them:

The culprit in those cases doesn't appear to be housing prices alone so much as the wildly complicated securities that investment firms created out of mortgages and a laundry list of other hard-to-price (and therefore risky) assets such as timber and highways.

The idea behind such financial concoctions was that if each security contained only a small share of each of those items, the overall security would be safer than the individual assets that underpinned them. But it hasn't worked out that way, according to Mason of Louisiana State University.

"New financial instruments are invented every day. Normally they get boiled down to a standardized form," he said. But this time, banks and investment houses sought to maintain high profits and a lock on the markets by keeping their inventions "customized."

The result today is that nobody can figure out how risky the new securities are, how much they are now worth or how dependent their owners -- mostly big institutional investors -- are on them.

"It's not a very efficient way to run a financial system, but how else are you going to find out?" Mason said.

That's precisely what happened to Fannie and Freddie, which are especially exposed to slumping housing prices because they own or guarantee nearly half of the nation's $12 trillion in mortgages.

Investors tripped over one another last week to sell shares of the government-sponsored but shareholder-owned companies, slicing Fannie's and Freddie's market values by nearly half. That prompted the Treasury and the Fed to rush out a plan that plants the federal government firmly behind the two mortgage giants.

Much the same thing happened to Bear Stearns in March. Investors in the nation's fifth-largest investment bank battered its stock, but what really sank the company was the fact that its lenders cut off the firm's lines of credit. Lenders feared that the brokerage was so burdened with bad mortgage securities, it couldn't repay what it had borrowed.

The Fed was forced to assume control of some of the least appealing securities and provide $30 billion in financing to pave the way for a fire sale to JPMorgan.

For Countrywide Financial Corp., the situation was similar. The largest private-sector mortgage lender watched its finances fall apart as late payments on its loans surged with tumbling home prices. The Calabasas-based lender was forced in January to let itself be snapped up by Bank of America -- for a sixth of its year-ago market value.

In each instance, the most prominent culprit behind the financial troubles has been a housing market that has fallen faster and further than almost anybody predicted.

As housing prices have continued to fall, they have exposed the weakness of firms built on the presumption that prices would keep rising. As banking consultant Ely, quoting legendary investor Warren E. Buffett, put it: "When the tide goes out, you find out who's swimming without their trunks."