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Thousands of US homeowners who had financed their houses through what have come to be known of as subprime mortgages stopped making their monthly payments. Those delinquencies, now about 15% of the total, set off a chain reaction that touched off one of the worst financial nightmares in years.
Early indications problems lay ahead were obvious back in February, when subprime mortgage specialist New Century Financial went bankrupt. But it was not until July and August before things got really ugly. By then, legions of investors were stunned to find out that buying risky assets in the mistaken belief that they were almost riskless can be costly. Collectively, they lost trust in the every institution involved: the mortgage banks that originated the loans, the investment banks that packaged them into so-called collateralized debt obligations, CDOs, the credit ratings agencies that displayed astonishing incompetence in rating CDO tranches AAA, and even some of the world’s most eminent official financial institutions. What have we learned? And what happens next?
Lesson 1: The Fed’s monetary policy response to the collapse of the high-tech bubble early in the decade was too aggressive and the easy money policy lasted too long. It set the seeds for a housing boom that is now in a painful process of unwinding.
Lesson 2: The US financial regulatory system is ill-equipped to deal with abusive lending practices of financial institutions not under the formal supervisory authority of the Fed or other traditional bank regulators. The majority of mortgage banks fall between the cracks. That was dangerous once their role in the mortgage financing suddenly escalated about four years ago. As the housing boom fueled soaring home prices, large numbers of potential home buyers were eager to get in on the action. Many were not creditworthy under normal standards. But the mortgage bankers developed variations on conventional loans to allow them to borrow. Subprime mortgage products offered low teaser rates to attract customers. They let applicants lie about their incomes and put up small or even zero down payments. But those borrowers would have to accept stiff prepayment penalties, a sharp break from normal US customs, and agree to pay sharply higher interest rates when their initial low rates were adjusted in a year or two. By 2006 over a quarter of all new mortgages were subprime. A more responsive regulatory system would have stepped in to catch the most abusive tactics before thousands were trapped in loans they would likely not be able to carry.
Lesson 3: Liquidity of securitized financial assets can’t be taken for granted. The mortgage bankers that originated subprime loans never intended to hold them. They were effectively in partnership with Wall Street firms skilled in creating mortgage-backed securities, a mature business dating back to the 1980s. But the new instruments they created, the CDOs, were different. The individual loans that were pooled and sold into the capital markets were generally uninsured, unlike the familiar mortgage securities packaged by GMNA, Fannie Mae or Freddie Mac. That exposed the institutional investors and hedge funds that bought them to credit risk, whether they realized it or not. So the new CDOs were much more fragile than their engineers (or the ratings agencies) had assumed. Once CDO prices started to fall, the secondary market became disorderly, liquidity essentially dried up, and trading screeched to a halt. Valuing the securities became virtually impossible.
Lesson 4: Investors have to do their own due diligence and not rely on marketing hype or dubious credit ratings. Many sophisticated investors purchased CDOs containing subprime mortgage-backed securities without fully understanding what they were buying. They relied on the reputation or sales pitch of the investment banks that issued the CDOs. And they took for granted that if the rating agencies judged that a particular tranche should be rated AAA, it was nearly the same risk as a Fannie Mae or Freddie Mac security. Once that misplaced trust was lost, the buyers went on strike, and the repercussions were not limited to the subprime mortgage securities market itself. Even the largest banks stopped trusting each other.
Prospects: Timely action by the Federal Reserve has helped calm the situation, which is no longer explosive. The Bush administration and the Congress are discussing how to help delinquent borrowers avoid foreclosure. That will help contain losses on CDOs with subprime loans. Consumer protections will be strengthened, either by the federal or state governments. Investors will shy away from CDOs for some time, but securitization of commercial loans will resume with perhaps some investor-friendly improvement in terms. The sense of crisis will vanish, as it already has in the stock market.
But the perpetrators of the summer financial nightmare will not regain the full trust of the world’s investors for a long time to come.
