I have been wrestling with posting about the remarkable global economic occurrences triggered by the sub-prime mortgage meltdown in the United States, but I’m still not entirely sure I fully appreciate what is going on, let alone have anything helpful to share with Credit Slips readers. I am astounded not just at the scope of the crunch (as in its penetration around the world) but also the depth of the turmoil (commercial paper is being hit because of sub-prime mortgage jitters?!). As I struggle to comprehend just what is going on, I’m left with a couple thoughts/questions.
1) Is what we’re seeing here like a macro-economic manifestation of the Two-Income Trap? That is, we thought we were making families better off with the entry of the wife into the workforce. It turns out, rather than diversifying risk we were inadvertently multiplying it. Is this just what happened with bundling and packaging out sub-prime mortgages? Instead of healthily diversifying risk, all we did was spread around the scope of possible entities (German banks!) to be hurt in the event of a collapse.
2) Can risk every be priced "accurately"? It seems to me that as investment funds chased higher and higher returns (which we can blame on, pick your scapegoat — how about cheap Chinese currency forcing a huge trade deficit and concomitant buy-up of U.S. debt?), that there was increasingly willful blindness regarding risk portfolios. Was it really that hard to foresee CDOs eating up through the tranches to even the "safest" tier? Even the quantiest of quants seemed to bet wrong, which strikes me as a sober reminder that humans, after all, oversee these programs and continue to suffer cognitive frailties.
3) Is it possible to isolate the effects of something like the mortgage market to mortgage investors? Tough love regulators of course don’t want to respond to "mere losses" in the investment markets by cutting interest rates, which should be the province of monetary policy, although that won’t stop them from cheating (ie., achieving the same effect, admittedly with more control, by injecting the sorts of funds that the Fed and ECB have just done). But as we’re seeing, we can’t just sit by and let a supposedly discrete group of investors take their lumps — when credit gets squeezed in commercial paper, we realize it’s just not that easy when credit gets crunched. Call these what you want ("externalities" or whatever), but it strikes me that we’re coming to the painful conclusion that the economic dislocation of Jack losing his sub-prime financed (declining valued) home involves a lot more pain than just that felt by Jack. (And let’s also not forget that Jack’s hurting too).
I wish I had more learned or scholarly insight for readers, but I find myself intellectually overwhelmed….
Comments
5 responses to “Musings on Sub-prime Meltdown”
I completely understand. Here’s how I (a non-economist) have begun to think about it – using the way I’m used to thinking, as an IT person with a psychology background.
We have the sub-Prime loans. These are, simply, risky. But there’s a market there, so people are attracted to it and provide the service.
Throw in all the new stuff with hedge funds, selling off debt, etc. and you had people assume they were spreading the risk around – and also minimizing impact. Everyone wins, right?
The idea of course is that risk gets spread around so impact is minimized for any one individual person or entity. The problem is that by spreading it around this way it’s far harder to evaluate it – and thus unable to evaluate, you can take on way more risk than you should.
Also, there is an obvious economic network here of interests, loans, investments, etc. Impact may be minimized for any one entity, but also the economic systems ensure that impact is felt quite widely – it travels. The power to spread risk is the power to transmit the results.
So there is an attraction to the market, a way to minimize one’s risk with a network of dependancies – that unfortunately let impact be transmitted. Risk is harder to measure so builds up to high levels that people are not aware of due to abstraction.
And when something like the subprime fallout happens, people are not only impacted, they’re impacted deeper than they thought and they can’t evaluate how much they are impacted. Panic results.
Hi John,
Just a quick comment. It is amazing how everyone seems to be blaming the current credit crunch on subprime mortgages. This is a mistake. It is like blaming a runny nose on a headache when the real source of pain is that you’ve got the flu. Subprime just happened to be the first symptom to appear in a credit bubble that has infected all of fixed income. High yield corporate bonds are similarly at risk. With a huge pipeline of new issues getting bloated further with delayed issues, it is a matter of time before high yield gets “marked to market” and then some more pain will begin as default rates increase causing stress on an overleveraged CDS market.
Easy credit over many many years has inflicted all of fixed income and subprime was just the first symptom to appear. The subsequent problems were certainly not caused by troubles in subprime and now we’re feeling the impact of coming down with the flu.
Best regards
I’m no expert either. But one thing that seems to have magnified the effect is that players all the way up the line have been using borrowed money to buy their investments in subprime mortgages (and other mortgage instruments as well). By leveraging the acquisition with borrowed money, funds were able to dramatically improve their returns. But that same leveraging led to cash flow problems when the income from the underlying asset pool was insufficient to service the outgo on the loans taken to buy the asset pool. Then, as lenders became nervous about the real value of the underlying asset pool (and valuation is highly uncertain because there is no “public market” to set value — so its worth what the holder says its worth, until they actually have to sell it), they insisted on more collateral to back up their loan positions — but there was no more collateral to be found. And as credit tightened or dried up entirely, it became impossible to “warehouse” new mortgages to generate new collateral. Lenders too found themselves in a tight spot because, if they foreclosed on the underlying collateral pool, they would be the next stuck party, because they themselves could not find buyers for the collateral package.
It’s easiest to see at the original level — the mortgage companies that originated and packaged these mortgages. New Century, American Home Mortgage, Aegis — they are filing bankruptcy right and left. But the same leveraging was taking place up the pipeline, at the level where CDO’s were created. Borrowed money was used to acquire the assets to back the CDO’s, and the same issues have arisen. That, apparently, is why Bear Stearns, and now Goldman Sachs have had to either liquidate positions or run for equity to cover positions.
When investors can no longer trust the valuations they are being given, or the ratings either, for that matter, and they flee, then there are no buyers for future product, leaving the funds gasping. Not unlike being in widget manufacturing, and watching your widget market dry up, I suspect.
There appears to be similar structural problems with collateralized loan obligations, which use loans to companies as collateral for these instruments. Again, if the cash flow starts to suffer, or the valuations are called into question, then both investor appetite and lenders’ willingness to continue to lend can dry up. I understand that many of these CLO’s are backed by so-called “covenant-lite” loans — loans with fewer covenants to breach, so that they won’t pop up as defaults, but which also may be shakier than their “non-default” status would lead one to believe. When these loans really do start to unravel, then faith in the entire portfolio begins to falter.
No one seems to know what will be the impact of credit default agreements, the insurance agreements out there, which not only “insure” actual holders of debt from the risk of default (what if the counterparty to the swap defaults? no one knows the answer), but which are also used as a form of “side bet” by parties both of whom are strangers to the actual debt. The terms of these instruments are murky, not subject to public regulation, and their enforceability has, I am told, yet to be tested (I mean, in terms of court enforcement). Who knows how this plays out? But there is said to be something in the neighborhood of $25 trillion worth of such deals (credit default obligations, swap agreements, and the like).
I am a consumer/small business bankruptcy attorney in Austin, Texas. We have been seeing the microeconomic impact of this issue for two or three years and it has been building steadily since that time. More and more people are buying more home than they can afford based upon inadequate information from the lender/mortgage broker/title company. They qualify borrowers for a mortgage based upon their ability to pay the payment amount at closing, never mind that it is an interest only loan with a teaser rate going in. The borrower is comfortable making the payments at 4% interest only, but they feel a pinch when it goes to 6% in year three and a little pain when it goes to 8% in year four, and then feel the real pain when it goes to 9% and principal kicks in in year five. The borrower who started out with a $1000 a month payment is now paying double that amount (or more) and just doesn’t have the income to make the payments. On top of that add all of the investors who are buying to flip (often with little or no money of their own in the deal) and it is no great wonder that the market went beyond reality. Eventually the music stops and we realize there are not enough chairs to go around.
One issue which has not been getting enough attention (in my humble estimation) is the impact the real estate correction will have on consumer spending. One of the results of all this cheap money being out there and the increasing value of homes and the corresponding increase in home equity has been the “home equity ATM.” People have been borrowing against the ever increasing equity in their homes and using that money to but consumer goods, or take vacations, or whatever because the interest rates on the equity loans have been cheaper than more conventional forms of consumer credit (ie, credit cards.) Consumer spending has been the driving force in the economy for several years. With the end of the housing price escalation and the reluctance to make what will now clearly be “riskier” loans, the home equity ATM is out of cash. Where is the money going to come from to replace the billions of dollars that consumers have been pumping into the economy? If there is no source of such funds, what impact will that have on consumer spending? If there is a significant decline in consumer spending, what impact will that have on the broader economy? Can you say recession?
michaelbaumer,
Good point there. I’ve seen a lot of “ATM” equit ads over the yeas and do have to wonder what’s going to happen.
Another factor to consider – what is this impact going to do to people going to school? That may sound strange, but this is going to hit a lot of families, and lower the chances for kids to get into college, people to return to college, etc. How’s that going to affect the insane school prices?