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.
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Never assume that stock markets are trying to tell you something. The short-term message of the markets is mostly just noise, whether stocks crash, soar, or coast. Financial markets in general, and equity markets in particular, have a well-documented tendency to under-react or overreact to news, and when they aren't doing that they are often reacting (so to speak) to no news at all. The notion that Wall Street is providing a deeply informed running commentary on the state of the economy is a plausible idea, and it would be so nice if it were true. It just happens to be empirically false. Stock markets go up, and then they go down. As they bounce around, that is about as much as you can say with any confidence.

That is a point worth bearing in mind when something dramatic happens, as it has in the past couple of weeks. Global stock markets have been hammered. The recent declines might very well mean nothing—but that doesn't mean they are useless. They can serve a purpose if they draw attention (albeit erratically and belatedly) to some uncomfortable realities. For the moment, they seem to be having that effect. The falls have drawn closer attention to the housing market, and especially to the condition of subprime mortgage lenders—banks and other institutions that have lent money to customers with poor credit. Whether the Dow Jones industrial average bounces back up over the coming weeks or keeps dropping, the problems in this part of the economy are real, and so are the broader risks that they pose. There has been too much complacency about them, and it is good that people are starting to pay more attention.

The subprime mortgage business has devoted the past couple of years to enlarging American households' appetite for debt—quite a challenge when you remember that the United States already had a very low personal savings rate by international standards. Unorthodox mortgage lending has played its part in pushing that rate down from about 2 percent during the first four years of this decade to between 0 and minus-2 percent since the second quarter of 2005.

Subprime lenders have not been content merely to lend to people with poor credit histories. They have pushed new kinds of loans in their direction as well: Option-ARMs, for instance. These are loans that start off with a low fixed interest rate and then after a year or two switch to a variable rate. A feature of this kind of loan can be that the principal grows during the first part of the term: It is called "negative amortization." The borrower is not paying down his debt, he is (perhaps without noticing) adding to it. And recall that he probably borrowed more than he could afford to in the first place. Ingenious.

But there seems to be no limit to the cleverness of subprime lenders when it comes to helping customers borrow more. Bolder innovations have included a loan that is amortized over 50 years (thus holding monthly repayments down) but that falls due in 30—so that at the end of the term, the mortgage is not paid off. The borrower has to refinance before that happens, or find the cash some other way. The finance firm that dreamed that one up, ResMAE, filed for bankruptcy last month.

Companies like ResMAE have opened up an entirely new terrain for innovation. One wonders where the frontier might lie. What could you get unsophisticated, weak-credit borrowers to swallow? How about a mortgage with zero monthly repayments over its entire term, up to the day it falls due? No, better, how about a mortgage that not only gives the borrower the traditional lump sum with which to buy a bigger house but also pays him $1,000 a month for the full term, to assist in defraying the expenses of living there. The only downside (see our full terms and conditions) is that when the loan falls due, the amount owed will likely be equal to the net worth not only of the borrower but also of all his descendants in perpetuity. But no problem. That's 30 years away—or let's make that 60 years away. You'll be very old! Or, if you're lucky, dead. If you feel you must, simply refinance at some point.

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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Clive Crook is a senior editor of The Atlantic and a columnist for Bloomberg View. He was the Washington columnist for the Financial Times, and before that worked at The Economist for more than 20 years, including 11 years as deputy editor. Crook writes about the intersection of politics and economics. More

Crook writes about the intersection of politics and economics.

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