Economy & Budget

The News on Wall Street

You know something has reached its peak when late-night comedians and Presidential candidates get hold of it. That’s what’s happened to subprime mortgages. This arcane subject has been in the news for months now, but it exploded in a blaze of headlines almost two weeks ago, leaving Wall Streeters in a state of near-panic, and ordinary people shaking their heads.

And naturally the political class has responded in its own inimitable fashion, with calls for more government control over the financial system.

The crisis on Wall Street is highly technical in nature. But just the same, it’s very real and very serious, and it has implications both for your own life and for national politics. So you need to  clearly understand what’s going on, and what isn’t going on.

Many have criticized the issuance of "subprime" mortgages, and securities based on them. A "subprime" borrower is just someone with a less-than-stellar credit rating. She will (and should) be required to pay a higher rate of interest, to compensate lenders for the somewhat higher risk that she will default.

But subprime mortgages aren’t a problem in themselves. Neither is the fact that these mortgages are bundled together into "mortgage-backed securities" that are then sold to investors.

The problem is that this asset class has been undergoing a risk-revaluation, and the process got messy, putting serious stress on global credit markets.

That in turn has raised fears of a slowdown in economic growth and possibly a recession. Just in time for a Presidential election.

How did the mess happen?

At this moment, there are more than $1 trillion in mortgage-backed securities, many with investment-grade ratings from agencies like Moody’s and Standard & Poor’s. Thousands of institutions own them, from banks to hedge funds large and small, across the whole world, and particularly in Europe.

Stresses appeared in this market earlier this year, when the issuance of new mortgage-backed securities ended with the boom in US housing prices. As fears rose that mortgage default rates might be rising in the US, naturally everyone’s portfolios of mortgage-backed securities became worth less. But how much less?

Mortgage-backed securities are illiquid, just like residential real estate itself. They rarely change hands once they’ve been sold to the original purchaser. So without pricing signals from new issuance or "marks to market" from secondary transactions, it’s difficult for portfolio managers to know exactly how much their securities are worth at any point in time.

That’s when the real trouble started.

Risk can be managed with standard mathematical and financial tools, but this requires continuous information on asset prices and volatility. Otherwise, risk edges over into uncertainty, which can not be easily managed. Under such circumstances, many holders of mortgage-securities would like to have started selling them, and in many cases were required to.

But without a liquid secondary market, they started selling other securities instead.

Some observers, including myself, got alarmed when this became apparent several months ago. When stresses in one asset class get transmitted to others, the risk-covariance models that Wall Street depends on become severely disrupted. In the worst of times, this results in panic.

That happened in the Long-Term Capital Management crisis of 1998, and it’s happening today.

The bottom line is that the mortgage market in the US is healthy. Default rates are slightly higher than they have been, but only slightly, and to no worrisome degree. But combined with technical factors arising from the markets themselves, this was enough to trigger a major crisis.

About two weeks ago in Europe, a "credit crunch" erupted, in which many institutions became unwilling to lend in dollars to avoid further exposure to mortgage-backed securities. (You saw this in sudden spikes in overnight interest rates.)

The Federal Reserve, the European Central Bank and other central banks acted immediately to provide "liquidity," by temporarily creating new money. They continue to do so on a daily basis now, about $300 billion so far. In addition, the Fed Friday announced its intention to start cutting interest rates in the US.

The continuous open-market purchases of securities by central banks have helped, but have not stabilized the markets. The Fed’s discount-rate cut created a one-day rally that left many, including myself, impressed but not very impressed. We won’t know for days whether the panic has been washed out.

Did the Fed do the right thing? Yes. The Fed’s is the lender of last resort. The Fed exists to keep markets orderly when market participants shy away from risk. It doesn’t exist to bail out people who have made bad decisions, and that’s not what’s happening now.

Thousands of institutions are trying to reposition their portfolios, and they all need to do it at the same time. Many will close their doors permanently. The Fed and the ECB are trying to keep this process orderly by ensuring that credit remains available to execute the transactions. It’s still too soon to say how well they will succeed.

Widespread damage has been done that may take a year or more to sort out. Meanwhile, a large amount of capital will remain parked in risk-free assets like US Treasury debt.

This capital otherwise would have been available to fund economic activity. That’s the reason for ordinary people to be concerned about the Subprime Crisis of 2007. It presents a clear and present danger to the global economy.

Will we get a recession? I think the answer is more likely yes than no. The US is now the slowest-growing major economy in the world. Widespread weakness in credit markets is likely to reduce overall economic activity in the US.

It’s also possible a still-unseen economic slowdown was the cause of the financial stresses that touched off the crisis.

The stock market will probably recover but remain on the weak side. Large American businesses have a great deal of exposure to markets overseas. So their earnings should remain healthy enough to justify some improvement in stock prices.

Should we take political action to respond to the Subprime Crisis? No. President Bush was right to say that he has confidence in the Federal Reserve, and that the government’s response should be measured. Free markets are extremely complex, they’re too regulated already, and it’s dangerous to suppose they need to be "fixed."

Senator Clinton’s response was very shrewd. She betrays little if any sophistication about business or finance, but she knows a red-meat political issue when she sees one. Fortunately, her proposal (to create a pair of $1 billion funds to do God-knows-what) is not likely to further disrupt a $1 trillion-plus global market.

I often think that, to many people, the engines of finance are just that: well-oiled machines that hum away in the basement, quietly producing good and services, jobs and prosperity. And if there are problems, you can fix them as you fix the engine in your car.

But that’s not reality. The financial world is a world of people, not machines. It depends on deep webs of personal friendship among well-connected, powerful people. The Treasury Department and the Federal Reserve play a key role in this global web of trust, especially in times of stress, when trust becomes uncertain.

The world’s investors trust us enough to make the US dollar by far the largest reserve currency, and to make US government bonds the benchmark global credit. Their trust can be revoked with the greatest of ease and must not be tampered with through hasty and ill-considered legislation.


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