August 11, 2007

Subprime Meltdowns

What ever happened to the “hazy, lazy days of summer?”  Just look at what has been happening lately:  Equity markets are round the world gyrate erratically in response to the most recent fallout from the sub-prime mortgage market meltdown.  Pundits on television scream about financial chaos.  Pensioners in Paris are negatively impacted due to mortgages written in California.  What on earth is happening?

As concern grows about the ability of overextended American households to make their mortgage payments, equity markets in Canada, Europe, and Asia plummet.  The European Central Bank on August 9^th and 10th injects

 a total whopping 115 billion Euros to push down the interbank lending rate.  The ECB also promised unlimited support to “assure orderly conditions in the euro money market.”  On August 10^th the Federal Reserve said that it

would add liquidity into the market to push the Fed Funds Rate down to its target of 5.25% .

Leading up to this T.V. show host Jim Cramer has his own meltdown on CNBC claiming, in his usual understated way, that we are in a financial “Armageddon.”

So what should come next?  Should the Fed “throw open the discount window” as Cramer has screamed?  Should Fannie Mae and Freddie Mac step in and buy up all of these now hard-to-price, sub-prime mortgage backed securities?  Are we edging closer to a financial abyss?

Well…the economic future is, of course, difficult if not impossible to predict…but things may not be as bad as the balding host of “Mad Money” seems to think they are. 

Consider the outlook offered by William Poole, President of Federal Reserve Bank of St. Louis.  While Cramer rants “Bill Poole has no idea what it is like out there…”, Dr. Poole is a well respected monetary economist with a Ph.D. from the University of Chicago and decades of experience at the Fed.

So how did we get into this mess?  After detailing the evolution of the subprime lending market, Poole argues that the problem lies in part, with reputation.  Simply put, he argues that there were (and are) too many short sighted, undercapitalized mortgage lenders out there, who do not have their customers best interest at heart. 

Further complicating this situation, Poole argues, were financial market participants who ignored basic financial and economic fundamental concepts.  To quote Dr. Poole directly:

“One aspect of recent developments was odd and has turned out to be the source of much difficulty in the non-prime market.  The steep yield curve during much of 2002-04 period reflected investor expectations that short-term interest rates would be rising, which they in fact did.  Yet, many mortgage-market participants apparently did not anticipate this increase.  Of course, I would not expect average homeowners to be able to read the yield curve, but I find it odd that apparently sophisticated investors in non-prime mortgage-backed securities now claim surprise that many non-prime ARM borrowers are facing payment shock because of the increase in short-term interest rates over the past few years.  Apparently driven by the prospects of high fee income and substantial spreads on non-prime ARMs, mortgate originators persuaded many relatively unsophisticated borrowers to take out these mortgages;  then, investors willingly purchased them when they were securitized.  Many of these mortgages are now in default…”

So what were are seeing today is the market punishing bad decision making by many in the mortgage-backed securities market.  Poole argues these financial market participants didn’t even know the basics about the term structure of interest rates.  Commercial banks who have lent funds to those involved in these markets are right to be worried.  But these commercial banks may be just as much “to blame” for this market inefficiency.  What makes this all the more confusing is no one knows who faces what exposure.  Since the securitized mortgages have been sliced and diced into various tranches it is unclear who holds what.  Thus, commercial banks are finding it difficult to sell the mortgages that they have written and they are cautious in to whom they lend new money.

So what we have today are the central banks reacting to a credit crunch.  This is not the first time this has happened and probably will not be the last!  What is interesting is the different reactions between the ECB and the Fed.  The ECB intervenes in financial markets differently (and less often) than the Fed does and the ECB has traditionally been more “hands-off” in dealing with financial crises.

But it wasn’t so this time.  The ECB went to much greatly lengths to calm nerves in money markets than did the Fed.  Part of this might be due to the larger run up in the inter-bank lending rate in Europe (4.7% versus the 4.0% target) than in the Fed Funds market (5.75% versus the 5.25% target).  Or it might be that the ECB is seeking to calm nerves across the commercial paper market in Europe which seems to be going through a more severe liquidity crunch than markets in the U.S.

 But let’s be clear:  the ECB and Fed did NOT intervene in reaction to the equity market price slides.  Neither central bank targets equity prices (nor should they).  The injection of reserves was done because of issues of liquidity in the banking sector, NOT because of equity prices falling.

So, what will the future hold? 

Back to Dr. Poole’s speech, watch for some major changes in the regulation of the mortgage market in the United States.  Don’t be surprised to see the Fed begin to regulate mortgage brokers (currently they are regulated by the states).  Also look for a major overhaul of the Truth In Lending laws, with explicit warnings for households who agree to ARMs, interest only and negative amortization loans.  A Democratic Congress may even push to outlaw some of these financial instruments.

In the end, I think history will show that the “academic economists” such as Poole and Bernanke, will get it right.  These same “academic economists” that Cramer and his ilk bellow are “out of touch” will be shown to have gotten it exactly correct:  they understood the difference between symptoms and causes of problems.  They addressed the symptoms (insured liquidity) without going overboard, and took steps to correct the causes of the problem.  Cramer may have a larger TV audience, but thank goodness the Pooles and Bernankes are the ones guiding policy.

Regards,

MB