Historical perspective on the sub prime problem

Ed Lotterman always writes an interesting piece and this is no exception. Fortunately we still have Gary Stern in charge over at the Fed and he understands the credit market better than anyone around these parts.  Here's is Ed's article: Underlying Ills intensify Sub prime perilEDWARD LOTTERMANSubprime mortgages are the Balkans of the U.S. economy. Nineteenth-century German Chancellor Otto von Bismarck famously predicted that the next great European war would stem from "some damned silly thing in the Balkans." Over 20 years later his prediction proved tragically correct when the assassination of an Austrian archduke in Bosnia touched off World War I.We won't wait nearly as long to see if the mortgage powder keg blows up in our economy.Home mortgage financing evolved dramatically in the 1980s as financial institutions began to buy pools of mortgages from the banks and mortgage companies that actually had made loans to homebuyers. These institutions then sold mortgage-backed securities. These essentially are specialized bonds secured by mortgages and that move most of their risk to investors like pension funds, insurance companies and mutual funds.Such securities are not all the same. For any given pool of mortgages, there are different "tranches" or slices that vary by risk. Investors can buy a low-risk tranche that is first in line to receive any payments or a high-risk one that is last in line and that will absorb all the losses if mortgage borrowers default.These securities in turn made more money available for mortgage lending and allowed mortgage originators to offload risk onto those more able — or at least more willing — to absorb it. Investors gained access to a new investment opportunity besides traditional stocks and bonds.As mortgage securitization boomed, packagers devised more complex divisions of risk. Moreover, confident of their ability to manage risk, they began to buy pools of riskier and riskier mortgages.Mortgage originators found they could make money by extending mortgage loans to borrowers with low incomes and poor credit records, charging higher interest rates for these subprime loans. To make payments manageable, they offered adjustable interest rates, initial periods with no principal payments and even initial periods during which the payment did not cover all interest due so that principal owed ratcheted up each month.Originating and packaging such loans was so profitable that many companies specializing in it were bought out by larger investment banks or had IPOs and became publicly traded corporations.Everything seemed great as the economy grew and house prices rose. One or two good years of appreciation turned many a risky mortgage into a well-collateralized one.However, when the housing boom slowed and economic concerns grew, buyers of subprime mortgages became skittish. So lenders agreed to buy back any mortgages that went into default within 90 days after being made. Of course, this increased their risk exposure.Anyone with a sense of history could see what was coming, but markets were blasé. As recently as March 1, Bear Stearns issued an upbeat report on one subprime lender, New Century Financial. Its stock already had fallen 50 percent to a price of $15. The Bear Stearns' analyst thought it was a bargain to be snapped up. Twelve days later, the price had fallen to near zero and the New York Stock Exchange was delisting the stock.There are three types of potential losses. First, investors who bought shares in New Century and similar companies will lose as their shares drop in value — perhaps to zero — as the firms write off losses. Secondly, banks that lent to subprime originators or investors that recently purchased tranches including mortgages in default will suffer delays in being repaid because of these companies' illiquidity. If the firms go bankrupt, they may suffer complete loss.Most importantly, hundreds of pension funds, mutual funds, endowment funds, insurance companies and hedge funds own mortgage-backed securities that may be far more risky than anticipated. If worst fears about the extent of rising mortgage defaults prove true, many such investors will suffer large losses. Some will go broke.The scope of the problem would be less important if the underlying economy were sounder. The assassination of Franz Ferdinand did not cause World War I. It was just the match that ignited a bonfire already full of tinder. The fuel was the underlying tensions between European nations.Today's underlying problems include unsustainable U.S. budget and trade deficits, the aftermath of an unprecedented run-up in U.S. housing values, a roaring Chinese economy stoked by an unsustainable exchange rate policy, and high energy costs. Subprime mortgages thus pose a greater danger than if such imbalances did not exist.Treasury Secretary Henry Paulson, Fed Chairman Ben Bernanke, Fed Governor Kevin Warsh and others have stated recently that the U.S. economy is strong and that financial market problems are minor. One may take heart from these reassurances. But keep in mind another of Bismarck's adages, "Never believe anything in politics until it has been officially denied."