The recent rumblings in the financial markets may well have your head spinning, and you are not alone. If it seems as if there is a lot of confusion and even irrationality, you are pretty much on target. Let’s take a step back and get some perspective.
“Subprime” mortgages began when new credit information resources made it possible to extend credit to folks who were traditionally excluded, thus allowing many more to achieve the dream of home ownership. That was (and is) a very good thing. The problem arose when these mortgages were securitized and sold in large bundles to investors. As they were gobbled up by yield-hungry funds, some lenders became more aggressive, using various schemes (such as negative amortizations in the early years or very low initial interest rates) and more relaxed underwriting and documentation requirements to induce additional loans. To make matters worse, the investment pools that were buying the loans often did so primarily with borrowed money in order to raise the returns they were receiving on their “cash” commitments.
All of this works fine as long as prices continue to go up; the rising equity values of the homes, like any type of inflation, can hide a multitude of sins. As has been the case for centuries, however, markets do not work that way¯and we never learn!!
Even so, if you calculate all of the mortgages in this category (overall credit quality is quite acceptable, and the subprime segment is only about 14% of the total), the probable foreclosure rates in a struggling housing market, and the likely losses when all is said and done, you get a number around $100 billion to $150 billion. That is a lot of money for sure, but not enough to stifle a multi-trillion dollar global financial system. So what happened?
Things are now integrated like never before, and this was the first situation of this nature to occur in the “online” world. Moreover, this was the first time it had happened since a lot of new (largely foreign) money entered these types of investments. These funds tend to be “headline” driven. Markets are remarkably efficient, but they do overreact in certain situations. Computerized trading also played a role, as the tendency of institutional investors to travel in packs is now reinforced by machines making preordained decisions without the benefit of wise old heads who could step back and take a deep breath.
Mechanically, the losses in the mortgage funds lead to “margin calls” which require that additional funds be committed to cover declines in the value of the mortgage pools purchased with borrowed money. Investors then sell other assets to cover these losses, and a chain reaction starts. At the same time, knee-jerk reactions such as the French government’s freeze of subprime mortgage funds created a feeding frenzy. The “headline” money then decides that all residential lending is bad, and funds start to dry up. The market demands stricter underwriting criteria, which is probably good in principle but, if carried too far (and it always is at the outset), it can turn perfectly good loans into bad ones. Regulators will also get involved in setting criteria, but the market will be a far tougher taskmaster.
It appears that the central banks of the world (especially the Federal Reserve System) will respond in a productive manner. After the French fiasco, they immediately pumped money into the system to assure liquidity. If you ever wondered how they do this, they simply buy securities. If I buy a security from you, we are merely trading cash and bonds among ourselves. If the Fed buys a security from you, however, they pay for it with “new” money that wasn’t in the system before.
The Fed also lowered the discount rate (the rate at which banks borrow from the Fed) by ½ point, extended the time period of such loans from overnight to 30 days, and allowed an expanded range of security to be used (including mortgages). The message was simply that liquidity was available to the markets. Although it hasn’t happened as of the time I picked up my pen, the Fed will also likely lower the Federal Funds rate (the rate at which banks borrow from one another) as well in the near future. These actions help to calm markets and are reasonable responses to the current environment.
There were clearly other factors involved, but this is the gist of it. At the end of the day, the underlying economy is quite healthy, and there is still a lot of money out there for investments (trillions of dollars, in fact). The tail definitely wagged the dog, and it will take a while to work through it. I would like to be able to say we will learn lessons from this debacle that will serve us well in the future, but centuries of evidence prove otherwise.