How on earth did the subprime mess come to this?

It’s not easy to comprehend or explain the linkages from loans to bonds to credit derivatives and back to loans (the unwillingness to make new ones of any kind!), which is why I’m taking another stab at it. This time around, I learned that the bigger threat is not what we know about these complex credit derivatives, but what we don’t know.

“The most interesting aspect of the ongoing subprime saga is not what it says about the U.S. mortgage market or the U.S. consumer but what it says about the impact a lack of transparency in financial market risk can have on markets overall,” writes Gail Fosler, chief economist at the Conference Board, a business research organization based in New York, in the July/August edition of “Straight Talk.”

That lack of transparency in risk has to start with a lack of transparency in the structures themselves. If an investor doesn’t know what he owns or what it’s worth, how can he assess the risk, not to mention hedge against it?

“Market risk is a major component of the rating,” says Joshua Rosner, a managing director at Graham Fisher & Co., an independent research firm in New York. With illiquid securities created by slicing and dicing pooled mortgages and other loans, “market risk is a greater issue” than credit risk, he says.

Speak No Evil

Many investors use one of the ABX or TABX indexes, which are linked to subprime bonds, to hedge their CDO exposure. That drives down the price of the index, making it “less and less effective as a hedge against long-duration instruments, such as CDOs,” Rosner says.

When it comes to credit risk, full disclosure isn’t exactly the mission statement at the rating agencies.

“The rating agencies put out their pre-rating model for issuers to structure a deal,” he says. “They don’t share the criteria with investors,” who would benefit from knowing what metrics rating agencies consider in downgrading collateralized mortgage and debt obligations. The effect is to create the impression that the process is “random and subjective, not transparent or replicable,” Rosner says.

It’s not easy to ascertain the yield, generally reflected as a spread over Libor, on variously rated tranches of CMOs or CDOs. The most common response to my query about some benchmark for AAA tranches was, “it depends.”

On what?

Cyber What?

Raising the veil on these structured products might have tempered demand for them over the last few years. It surely would have smoothed what’s become a bumpy road today.

So how can we increase transparency in a complex market where everyone involved profits by keeping the investor in the dark?

One way would be “a large lawsuit by a well-capitalized institution,” says Sylvain Raynes, a principal at R&R Consulting, a structured valuation boutique in New York.

Another way would be to utilize “cybernetics, or the theory of feedback control, in both primary and secondary markets,” he says. (Here I thought the structures themselves were incomprehensible. Now I find out cybernetics is the key to enlightenment.)

In the secondary market, this would entail acknowledging that “structured securities have dynamic credit quality,” Raynes says. As the credit quality changes, it “should be reflected in the rating immediately.”

Dynamic Ratings

The trustee of every structured finance deal publishes the monthly servicer’s report, sending it to all parties involved, including the investor.

Like any investment, this one comes with an implicit warning of “caveat emptor.” With complex derivatives, the investor may not understand the mumbo-jumbo in the servicer’s report, which raises the question of what he was doing investing in them in the first place.

But that’s another matter. For our purposes here, the issue is the “need to introduce secondary market monitoring in a meaningful way,” Raynes says.

The primary market needs to develop “valuation standards,” which “could have avoided 90 percent of the problems,” he says. “It is possible to know a priori that a deal does not work, that the amount of securities in the transaction is too high.”

2 + 2 = 3

The deal may make “linear sense,” with $100 million in loans for $100 million of securities. “But the obligors are too risky for the bonds being issued.”

Given the opaque nature of the securities and structures, no wonder their risk isn’t obvious.

“The lack of transparency around risk creates an incentive for indiscriminate market turmoil because investors don’t know how to selectively implement their risk aversion,” Fosler says.

That’s what happened earlier this week, when investors withdrew from anything that didn’t carry a AAA rating and the backing of the full faith and credit of the U.S. government.

The policy of don’t ask, don’t tell works fine during good times. In a low interest-rate environment, investors reach for yield and clamor for anything that offers 20 extra basis points.

When things get dicey, the lack of transparency contributes to risk aversion. At times like these, the formula is simple: Don’t ask + don’t tell = sell.

To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net .