UNDERSTANDING THE SUBPRIME CRISIS

• First of all, some context.  How is it that a financial mess concentrated in one part of the mortgage business—subprime loans—has frozen up the credit markets, sent stocks wildly up and down, caused the collapse of one of the most respected financial banking giants, Bear Stearns, left the economy in a serious recession, and forced the Federal Reserve to take a bold, unprecedented series of actions?  [I am borrowing some of my insights and information here from a recent column by David Leonhardt.]  “It really started in 1988, when large numbers of people decided that real estate, which still hadn’t recovered from the early 1990s slump, had become a bargain.  At the same time, Wall Street was making it easier for buyers to get loans.  It was transforming the mortgage business from a local one, centered around banks, to a global one, in which investors from almost anywhere could pool money to lend.  The competition brought down fees and spurred innovation, much of which was undeniably good.  Why should someone who knows that they’re going to move after just a few years have no choice but to take out a 30-year, fixed-rate mortgage?”  Along came a group of people—global investors—flush with cash from Asia’s boom or rising oil prices, who wanted a good return on their investment.  Wall Street then provided the vehicle—subprime mortgages.  “Because these loans go to people stretching to afford a house, they come with higher interest rates—even if they’re disguised by low initial rates—and higher returns.  The mortgages were then sliced into pieces and bundled into investments, often known as collateralized debt obligations, or CDOs (a term that appeared in [newspapers] only three times before 2005, but every week since last summer).  Once bundled, different types of mortgages could be sold to different groups of investors.”  Investors then leveraged their investments.  They bought these bundled mortgages on margin—putting say $1 million down on a $100 million investment, borrowing the remaining $99 million.  Homeowners did the same thing, buying a home with very little money down.  Alan Greenspan made it easy as well, sharply reducing interest rates to prevent a recession in 2000 after the dot.com bust in the stock market.  The point is that all these investments were highly risky!  The Federal Reserve, investment banks and virtually every major Wall Street firm believed that home values would continue to rise and therefore the normal rules of investment did not apply.  “The American home seemed like such a sure bet that a huge portion of the global financial system ended up owning a piece of it.  Last summer, many policy makers were hoping that the crisis wouldn’t spread to traditional banks, like Citibank, because they had sold off the underlying mortgages to investors.  But it turned out that many banks had also sold complex insurance policies on the mortgage debt.”  When homeowners could no longer make the payments or could not easily “flip” the house, trouble naturally resulted.  The problem of course is that so many of these deals were heavily leveraged.  If one thing goes wrong, the house of cards built on this debt would collapse.  “The toxic combination—the ubiquity of bad investments and their potential to mushroom—has shocked Wall Street into a state of deep conservatism. . . So firms are now hoarding cash instead of lending it, until they understand how bad the housing crash will become and how exposed to it they are.  Any institution that seems to have a high-risk portfolio faces the double whammy of investors demanding their money back and lenders shutting the door in their face.”  Hence the collapse of Bear Stearns.  This conservatism has gone so far that it is affecting many solid borrowers and hurting the broader economy and aggravating Wall Street fears.  A recession could cause credit card and other debts to collapse as well.  “Bubbles lead to busts.  Busts lead to panics.  And panics can lead to long, deep economic downturns, which is why the Fed has been taking unprecedented actions to restore confidence.”

• Second, what the Federal Reserve did with Bear Stearns, in effect making it possible for JP Morgan to buy it, is unprecedented!  To some extent, this fits the pattern of what central banks around the world have been doing.  Bear Stearns is not a traditional commercial bank that took deposits from the public, but it is America’s fifth-largest investment bank, which funded most of its operations with borrowed money (aka “leverage”).  Robert Samuelson reports that “On average, the ratio of borrowed money to underlying capital for investment banks and hedge funds is about 32 to 1!!!!  Many of these loans—commercial paper, ‘repurchase agreements,’ bank credits—are backed by the securities owned by the borrowing financial institutions.”  Therefore, if lenders become worried about the worth of these securities, they might ask for more collateral or pull their loans.  This is what happened to Bear Stearns.  Deprived of its credit lifeblood, Bear Stearns had to collapse or be purchased by someone with credit.  In this case, JP Morgan—and the Fed provided the credit.  Therefore, the Fed is now making more and more credit available to more and more financial institutions.  It wants to avoid a “chain reaction” that could be fatal to the financial markets and the broader economy.

• Third, this entire mess raises a profoundly important question:  As David Ignatius has hypothesized, “The Fed has pledged itself to a rescue package whose ultimate scope is unknown but that will put at risk the nation’s most precious asset, which is the Fed’s credibility.  How much bad debt will the Fed have to assume?  Nobody knows.  Estimates of the subprime portion range up to $400 billion, . . . with losses in credit markets that could total at least $600 billion.”  Most analysts agree that this is the worst financial crisis to hit the US since the Great Depression.  We are in unchartered territory in terms of finance!  Good stewardship, wisdom and prudence and common sense have not prevailed in this subprime mess.  We are reaping the results of this mess and we do not know over the long term whether the Fed can really maintain stability.

See David Ignatius, Washington Post (19 March 2008); Robert Samuelson, Washington Post (18 March 2008); Robert Novak, Washington Post (20 March 2008); and David Leonhardt’s most helpful essay in the New York Times (19 March 2008). 

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