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The Pain, and Gain, of the Subprime Meltdown

By Sebastian Mallaby
Monday, August 13, 2007

The meltdown in financial markets may seem scary or mysterious, but it's part of a time-honored story. In Chapter One, a new financial instrument makes capital available to a new class of borrower, and the result is profits for the innovator along with gains for consumers. In Chapter Two, a group of not-so-smart investors misunderstands the novel instrument and bids its price up too enthusiastically; when the inevitable bust follows, the innovation is denounced as inherently dangerous. Then, in Chapter Three, the complaints blow over. The not-so-smart investors learn their lesson and the new instrument stabilizes. Financial innovation turns out to be beneficial without being scary, but by that time another newfangled instrument has emerged to frighten people, and finance is hauled before the court of public opinion -- again.

This is likely to be the story with the current subprime mortgage meltdown, just as it was with subprime's close cousin, the junk bond.

Junk bonds, you will recall, are a way of getting loans to companies that stand a big chance of defaulting, much as subprime mortgages enable people with questionable credit to buy homes. During the 1980s, the value of junk bonds in circulation went from nothing to around $200 billion, enabling dozens of fringe companies to innovate and experiment. Then, in the early 1990s about one in 10 junk borrowers lived up to their names and defaulted, and junk bonds were widely denounced. But the fuss was over quickly. By 2000, the value of the junk bond market had soared to $600 billion. Nobody doubted that fringe companies should have access to finance, provided that they compensated investors for the risk that they might fail.

The subprime story began in the late 1990s, around the time that junk bonds had become boringly respectable. Lenders figured out that there was no reason to deny mortgages to households with a history of poverty or unreliability; they should be welcome to borrow provided that they paid a premium to reflect their high risk of default. By 2006 subprime mortgages accounted for a fifth of all home loans, and the social consequences were marvelous. The homeownership rate, which had been stuck around 65 percent between the mid-1950s and the mid-1990s, hit 69 percent. Some 12 million new homeowners emerged, roughly half of them members of racial minorities. The American dream had been extended as never before.

But there was a mysterious feature to this story: Some subprime mortgages did not so much relax normal lending standards as abolish them wholesale. It's one thing to inspect a borrower's track record and forgive periods of unemployment or late credit card payments; it's another to suspend inspections -- which was effectively what the notorious "no-doc" loans were all about. The mystery was not that mortgage companies were happy to be reckless, since they resold the mortgages to investment banks that packaged them into securities: They were not going to be holding the baby if the homeowner went bust. The mystery concerned those not-so-smart investors who bought the investment banks' securities. Were they blind, or what?

Every boom-and-bust cycle has its expert enablers. The tech bubble was fueled by Wall Street analysts who talked up stocks they knew to be worthless; the Enron-WorldCom-Adelphia bubble was inflated by auditors who signed financial statements that were full of lies. In the case of the subprime delusion, the enablers were the ratings agencies, Standard & Poor's and Moody's, which assigned ratings to no-doc loans that failed to advertise the risks involved. When the tech bubble imploded, the chief victim was the day trader. In the mortgage market, we are discovering, the rating agencies' victims included unsuspecting European banks.

There's more pain to come in this shakeout. Now that financial markets are panicking, bystanders who never touched a subprime mortgage may get trampled. The European Central Bank led an international effort to pump money into the banking system last week, because private lenders were yanking back their money for fear that banks might be harboring unannounced subprime losses. Nobody knows where subprime trouble may be lurking, so every financial player has a hard time borrowing. All sorts of operations that depend on easy credit -- from private-equity buyouts to the leveraged trading strategies of hedge funds -- threaten to unravel.

But whatever the immediate turmoil, the eventual conclusion to the subprime story seems reasonably clear. When the dust settles, investors will have learned not to put blind trust in rating agencies, which are paid by bond issuers and so have an incentive to exaggerate how safe bonds are. And when the dust settles, the market for subprime mortgages will revive and thrive in dull obscurity. With financial innovation, it was ever so.

smallaby@cfr.org

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