Wealth of Nations March 2007

Wall Street's Housing-Market Makeover

Stock market declines have drawn attention to the housing market and especially to the condition of subprime mortgage lenders.

How could it ever be profitable to extend such loans? You would think that reckless borrowing and reckless lending were both self-correcting. Borrowers and lenders alike end up going bust: Neither will get nor deserve much sympathy, and it is nothing the rest of us need worry about. Well, the first part of that is already coming true, and perhaps the second part will as well. Maybe the damage will spread no further. But it might not be so easy. Everybody has something riding on this—including fiscally conservative types like you and me who are living only slightly beyond our means. It is a question of scale and dispersal. If the scale of the reckless lending has been great, the eventual crunch may dent consumer spending enough to shock the entire economy into slower growth, or outright recession. And if other segments of the banking industry have been drawn injudiciously into the reckless-lending business, there might be wider financial repercussions, too. It will not be just the ResMAEs of this world that suffer the consequences.

One of the earliest and most persistent pessimists on all of this has been Nouriel Roubini, an economics professor who runs a Web-based economic information and analysis service (www.rgemonitor.com). Roubini rightly points out that for months most financial analysts and commentators had denied that the subprime mortgage business was in serious trouble. That position is no longer defensible, with the count of dead or dying subprime lenders standing at 30 or more. The new complacency, according to Roubini, is to argue that the "carnage" and "meltdown" at the low end of the mortgage industry (many analysts are now applying those words to the subprime business) will cause no wider harm. That is not right, he argues, more persuasively than I would wish.

Roubini contends that subprime lending has been more than a niche business. "subprime" is a fuzzy concept in any case. Roubini estimates that a more broadly defined category of unorthodox loans plus orthodox loans to risky borrowers would account for about half of new mortgages granted in 2005 and 2006. (Consistent with that, an industry newsletter, quoted by The Economist, estimates that nearly 30 percent of new mortgages in 2006 were "alternative" products.) Default rates are increasing beyond the narrowly defined subprime category. If this makes mortgage lenders reluctant to lend across the board, to good and bad risks alike—and this appears to be happening—the impact on the housing market, and thence on the wider economy, could be powerful.

And Roubini argues that financial-market contagion is a danger as well. The reason is the close ties between many of the failed or struggling subprime lenders on one side and hedge funds, investment banks, and mainstream commercial banks on the other.

That's right, Wall Street is deeply implicated in the subprime lending explosion. The money behind those loans has come not from bank depositors but from the capital markets. The gathering and repackaging of mortgages into securities, which then get traded on the market like other financial instruments, has become a huge and up to now very profitable business. Firms like Goldman Sachs and Morgan Stanley wanted to see it grow, and they funneled their own and other people's money to the subprime lenders.

In principle, turning mortgages into tradable securities offers big economic benefits. It lets investors pick and choose the risks they want to bear. Ultimately that gain feeds back to borrowers in the form of lower interest rates—which is fine. The problem is that it made lenders careless. Even though, under the standard terms of mortgage-securitization contracts, lenders may have to take back loans that go sour too quickly, the ability to off-load their mortgages encouraged them to relax or abandon traditional prudential standards. They thought it would be somebody else's problem—and the pity is, it may turn out that they were right.

Goldman Sachs, for one, is not flinching yet. In a conference call celebrating record first-quarter profits this week, the firm's CFO, David Viniar, said that fire-sale prices for subprime lenders were a buying opportunity and that Goldman was interested in securing a bigger piece of the business. The bank's former boss, Treasury Secretary Henry Paulson Jr., visiting Tokyo last week, said something similar. He told reporters that he did not regard the housing market, or the turmoil in the subprime business, as a worry. "Some of the credit issues are there," he said, "but they're largely contained." Roubini thinks that is nonsense. We will see who is right.

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