The trauma that has seized world credit markets should have been entirely predictable and came about through a disregard of tried and tested
management theories and the basic rules of finance.
The shock that spread so fast from Wall Street was a result of some basic, simple but ignored financial management theories - most notably, what goes up must come down.
The very aspect that makes equity investment so appealing – that there’s no ceiling – also works in the opposite direction: there's a long way down.
The source of all the anxiety was a specific area of suspicious quality – the ‘sub-prime’ mortgage market in the US. The securities in question were ‘sub-secure’, mortgages extended to borrowers with poor credit ratings.
The theory was that by pooling all these poor quality investments, by the law of averages, the truly bad mortgages would be more than offset by the stronger ones, leaving the happy investors to enjoy the higher yields that invariably accompany a lower credit rating.
But the higher the interest, the greater the risk. What's more, there are other the simple rules that apply: the higher the yield, the greater the risk; and if you think you’re making much more money than somebody in the very same business, you’re not.
Whenever someone says they have eliminated risk from an inherently risky transaction, take no notice and walk away.
For more on management theories see http://www.thinkingmanagers.com/business-management/management-theories.php
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