Bubble and Bust

Saturday, August 11, 2007

BY THE HEIGHT of the 17th-century Dutch tulip mania, bulbs were selling for the equivalent of up to $76,000 apiece, and tulip options were trading on markets across Europe. The ensuing crash crippled the Dutch economy for years, establishing a cautionary model of speculative excess that investors have learned from, and ignored, in a seemingly endless cycle of bubble and bust ever since.

Today's tulip bulb is the subprime mortgage: a loan to a not terribly creditworthy person in the United States to buy a house that he or she really can't afford. Hundreds of billions of dollars worth of these paper commitments have be en made, gathered together and resold as bonds to hedge funds and banks all over the world -- which in turn have used them as collateral to obtain more loans, so they can buy more bonds, and so on. Now that home prices are falling and many unhappy U.S. homeowners are, foreseeably, defaulting, the whole business is unraveling. Some holders of subprime-backed securities, such as hedge funds belonging to the giant French bank BNP Paribas, literally can't give their bonds away. The world is in the grip of a liquidity crisis.

The Federal Reserve Board and central banks in Japan, the European Union and elsewhere wisely stepped in to provide enough money to get banks through the last few days of this scary week. It was a sound intervention because, in a financial panic, investors who once wildly overvalued assets can undervalue them just as wildly once the speculative fever breaks. A short-term cash infusion can help keep financial institutions going while they gather the information needed to reach calmer, more economically rational assessments of the risks they face. If all goes well, the credit crunch will stop spreading into the ranks of better-qualified borrowers, thus containing what has so far been minimal damage to the "real" economy from the subprime mess.

Another feature of the boom-bust cycle is that the bust is usually accompanied by well-intentioned but questionable policy prescriptions. Washington should look at ways to help those subprime borrowers who could service restructured loans to work out new terms with their lenders, so that they don't lose their homes.

But one unconvincing proposal is to let Fannie Mae and Freddie Mac, the two government-sponsored enterprises that already dominate the mortgage-backed securities market, buy up more loans. A bill to do that passed the House in May, and, in the past few days, Sens. Charles E. Schumer (D-N.Y.) and Christopher J. Dodd (D-Conn.), the latter a presidential candidate, have echoed the idea. The Office of Federal Housing Enterprise Oversight has capped Fannie Mae's portfolio at $727.2 billion (the level of Dec. 31, 2005), while Freddie Mac's $712.1 billion portfolio may grow only by 2 percent annually. The regulators imposed these conditions because of accounting scandals at Fannie and Freddie -- and it seems unwise to tap them for a bailout now, especially when such an action would leave them holding billions of dollars in new assets of ambiguous value.

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