Yesterday I had the privilege of listening to Mukesh Bajaj, PhD talk about his perspective on the subprime mess. Dr. Bajaj teaches a masters course at UC Berkeley on Securities Design and is Senior Managing Director at LeCG, an expert services company.

First, my admission that Dr. Bajaj speaks above my pay grade. He is an astute financial economist that the big boys of Wall Street, Banking and Fortune 500 call on. I make no claim to have understood the complexity of his analysis in detail, but I do believe I got the gist of his presentation and what it may mean to the average person on the street. (What you read here is my take on Dr. Bajaj’s presentation and may not accurately reflect his presentation due to my lack of sophistication.)

Dr. Bajaj believes that subprime instruments are here to stay and will actually increase in use in the future. Noting that 14% of first time (7.5 million) mortgages were subprime mortgages, Dr. Bajaj said that though there were certainly a few rogues in the lending industry, he does not feel that there were any big players with bad intent. This may not be at odds with Kathleen Day’s article if you consider her villains to be the rogues.

Dr Bajaj asks, “What would be their motive?” Lenders certainly would not intentionally take action that would lead to the carnage their balance sheets have experienced as a result of the subprime melt down.

Dr. Bajaj believes that the fundamental problems of the subprime mess stem from improperly designed securities. The Collateral Debt Obligations (CDO) used to facilitate subprime loans were a new application of a diversification instrument and any time you enter a market with explosive growth, there are going to be some bumps.

After the dot com bust and 9/11, capital started chasing the U.S. housing market. Foreign investment in the U.S. is favored because of our stable legal structure.

Dr. Baja believes that the subprime mess resulted from two basic fallacies:

• The benefit of diversification cannot diversify risk. In the long run, if things go south, somebody has to pay.
• Home prices would not decline. Prior to this time U.S. home prices had never declined on a national basis.

Rating agencies fed the frenzy because of financial assumptions based on misapplied historical data.

The subprime mess is being exacerbated and prolonged by the psychology of the market. We need to break the psychology of the market to prevent fear from becoming a reality.

Contributing to the negative psychology of the market and the panic is market-to-market accounting where the accounts are basing there assumptions on the most pessimistic view. This as a result of the Enron mess and despite the fact that the Enron mess has led to an increase in quality investment.

The subprime mess won’t abate until capital comes in to absorb foreclosures. Tighter lending standards are limiting capital investment. There is a vast pool of foreign investment looking for markets to invest in. If we don’t allow it into this country, it will go elsewhere like China.

Though we (HarperMees and other real estate agents) are noting a substantial increase in foreign investors buying San Francisco Bay Area real estate what is needed are deep pocket investors to step in and absorb the deeply discounted properties.

There were maybe twenty-five people in attendance for the talk - from Bank presidents to corporate board members to financial braniacs. The group also included several attendees from foreign nations. The grouped seemed to agree with Dr Bajaj that the write-offs on the CDOs have been too, aggressive and that many, if not most of them, are currently a good investment opportunity because they are now undervalued.

During the Q&A session, Dr. Bajaj made some interesting side comments.

• In 1960, the U.S. had 6% of the world population and 60% of the wealth. Today, we have 6% of the population and 25% of the wealth. AND we are wealthier than ever before. What the figures reflect is how much global wealth has grown not a deterioration of U.S. wealth.
• Less than one year of defense spending would eradicate world poverty.
• The best security possible would come from underwriting the education and well being of every human being. We have no idea of how many Einsteins are not reaching their potential due to poverty and lack of education.
• House prices reflect the future wealth of owners.
• Service oriented businesses are only as valuable as their talent pools.
• The level of violence in the world is lower than it has ever been. The media pulls attention to the hot spots.

On a side note, Dr. Baja said that the benefits of outsourcing may have run their course. At some point the costs savings of outsourcing stabilize as the expenses involved mediate between the two markets involved.

Dr. Bajaj has an incredibly positive outlook on the future and what is possible. He sees the result of working through this subprime mess as a positive evolution that will potentially bring more capital and wealth into the U.S. If we don’t allow our xenophobia to ruin everything.