The Big One?

There is a point in a good party when you decide either to stop and get home at a decent hour, or you throw caution to the wind and decide that there is no time like the present. In the current mess of the financial markets, how is it possible that any sane banker would not have noticed until now that the outrageous lending practices with US mortgages were leading to an unsustainable bubble. No, the better answer is that everyone knew the party was going to end some time, but since the hangover was going to be a doozy, the party rocked on.

And so we read stuff like this in the Globe’s Subprime Primer (which does actually provide good overview for the lay reader):

Suddenly, portfolio managers at money-market mutual funds are asking whether they really want to be investing in commercial paper that is backed by assets such as mortgages when the housing market is going bust. As a result, the trusts can’t find buyers for their paper, leaving them short of money.

At some point, when this crisis passes, there needs to be some reconciliation. These guys have been raking it in with multi-million dollar bonuses, and now their irresponsibility threatens the entire financial system.

Anyway, some background on the state of the crisis, as I leave the digital world for the trees for a couple weeks. A good description of the mechanics of what has been happening comes from Vox EU:

As the US housing bubble is working its way out, mortgaged loans go sour. Since the institutions that granted these loans have promptly sold them on – this is the securitization process – to other institutions, which sold them on to others, and so on again and again, those who suffer losses are the ultimate holders. There are so many of them, all over the world, that no one knows where the losses are being borne. It could even be you, through your pension fund or some innocuous-looking investment.

The second observation that all agree about, is that the total size of the now-infamous subprime loans, even augmented by normal mortgages, does not add up to a huge amount. Normally, most financial institutions should be able to absorb them with much damage. Of course, a few may have bought too much of the stuff and they will go belly-up, but that is how things normally are. Most significant financial institutions should be able to absorb those particular losses.

In fact, no one can claim to be surprised by the mortgage crisis. For years now, the consensus view was that the US housing market was undergoing a bubble. The implication all along was that a correction would occur, with all the consequences. The correction has been underway for months, and in slow motion, which gave plenty of time for all to make adequate preparations. To be sure, some brave contrarians may have thought otherwise and bet accordingly. But it would be a momentous surprise if all respectable large financial institutions did not ready themselves. So far, so good. Why the interbank market crisis, then?

Here comes the securitization story, and it is not controversial either. The dilution of risk is a good thing, no doubt about it. But it is generally the case that any good thing has some drawback. In this case the drawback is that no one knows who holds how much of these bad loans. Where things got bad is that, the same as many other human beings, and maybe a little moreso, financiers are prone to mood swings. When all was going well, they trusted each other as if they had gone to the same schools, which in fact they did. When the situation soured, they went at light speed to the other corner and started to suspect that everyone else was more in trouble, especially those they knew best because they went to school together. So the interbank market froze.

What to do about it? There is an angry sentiment out there that the foolish need to be punished and that the financial system needs to clear out the rot that has accumulated. Their message is that central banks should just sit on the sidelines. But there is good reason to believe that intervention is needed to soften the blow for the victims on Main Street, and to ensure that the crisis does not spill over onto the real economy and lead to a full-blown recession.

Some of the latter may be inevitable given how high real estate prices climbed, but there is definitely justification for softening the impact. And while a modest interest rate cut may take the edge off the reckoning, it does not seem likely that it will do the wonders of last time around. If things get really bad and monetary policy is ineffective, we’ll need to pull out our copies of Keynes’ General Theory, and let loose with fiscal policy.

In the meantime, it is not clear how this is all going to play out, and how much Canada gets sideswiped by what is largely a US story. There is much we do not know, and even though it seems like Canadian mortgage excesses were more rooted in low interest rates than irresponsible lending practices, there are many troubling points of exposure to the crisis in US financial markets.

Here’s what Paul Krugman recommends:

Many on Wall Street are clamoring for a bailout — for Fannie Mae or the Federal Reserve or someone to step in and buy mortgage-backed securities from troubled hedge funds. But that would be like having the taxpayers bail out Enron or WorldCom when they went bust — it would be saving bad actors from the consequences of their misdeeds.

For it is becoming increasingly clear that the real-estate bubble of recent years, like the stock bubble of the late 1990s, both caused and was fed by widespread malfeasance. Rating agencies like Moody’s Investors Service … seem to have played a similar role to that played by complaisant accountants in the corporate scandals of a few years ago. In the ’90s, accountants certified dubious earning statements; in this decade, rating agencies declared dubious mortgage-backed securities to be highest-quality, AAA assets.

Yet our desire to avoid letting bad actors off the hook shouldn’t prevent us from doing the right thing, both morally and in economic terms, for borrowers who were victims of the bubble.

Most of the proposals I’ve seen … are of the locking-the-barn-door-after-the-horse-is-gone variety: they would … have been very useful three years ago — but they wouldn’t help much now. What we need at this point is a policy to deal with the consequences of the housing bust.

Consider a borrower who can’t meet his or her mortgage payments and is facing foreclosure. In the past, … the bank that made the loan would often have been willing to offer a workout, modifying the loan’s terms to make it affordable, because what the borrower was able to pay would be worth more to the bank than its incurring the costs of foreclosure and trying to resell the home. That would have been especially likely in the face of a depressed housing market.

Today, however, the … mortgage was bundled with others and sold to investment banks, who in turn sliced and diced the claims to produce artificial assets that Moody’s or Standard & Poor’s were willing to classify as AAA. And the result is that there’s nobody to deal with.

This looks to me like a clear case for government intervention: there’s a serious market failure, and fixing that failure could greatly help thousands, maybe hundreds of thousands, of Americans. The federal government shouldn’t be providing bailouts, but it should be helping to arrange workouts. …

The mechanics … would need a lot of work, from lawyers as well as financial experts. My guess is that it would involve federal agencies buying mortgages — not the securities conjured up from these mortgages, but the original loans — at a steep discount, then renegotiating the terms. But I’m happy to listen to better ideas.