- The sub-prime mortgage lending boom has now turned fully
to bust. Mortgage delinquencies and defaults in the $1.3 trillion sub-
prime market have shot up to unexpectedly high levels, with surprising
speed. Numerous sub-prime lenders have failed or closed. Delinquent home-equity
loans are rumored to be attracting secondary market bids of 15 cents to
25 cents on the dollar. HSBC, a world class bank, has announced embarrassing
losses in sub-prime credit, and made corresponding management changes.
- Stock prices of major sub-prime specialists have collapsed:
a fall of about 94% for New Century Financial, 65% for Fremont General
and 85% for NovaStar Financial from their respective 52-week highs to
the March 9 closing prices. New Century is the subject of bankruptcy
speculation; the FDIC has put a severe regulatory clamp-down on all Fremont's
operations; NovaStar has announced that it expects little or no taxable
income over the next five years.
- This all raises a fundamental question about risk: If
private investors want to take credit risk, and borrowers want to take
a chance in order to own a house, should they be allowed to, even if it
might lead to consequences like the ones mentioned above? I'd say they
should. Credit is a central force in a market economy, and boom-and-bust
cycles are the unavoidable price of achieving the long-term growth that
markets -- and nothing else -- create. Without the freedom to make mistakes,
there will be no growth.
- Markets also have their own corrective responses. The
various segments of the sub-prime market have already raised credit standards
on their own (however belatedly). Credit has tightened for consumers with
lower credit ratings, as has financing for the sub-prime lenders themselves,
and for securitizations -- reducing liquidity for all of them. On top
of this, banking regulators have recently issued additional, tighter credit
"guidance" -- too late to avoid the problems, but probably in
time to help pro-cyclically push the market further down.
- Of course, some might reasonably wonder if the market
is self- correcting enough. How could all these problems arise, you might
ask, given our massive computer power manipulating mortgage data with sophisticated
models built by mathematical experts? The former CEO of Household International,
which became the sub-prime arm of HSBC, reportedly bragged that his operation
had 150 Ph.D.s to model credit risk. Shouldn't this make us a little nervous
about the large sub-prime securitization market -- with securities tranched
and sold to yield-hungry investors based on the models of the credit-rating
- Focusing too much on these questions, however, somewhat
misses the point. Rather than obsessing over statistical measures of risk,
much more important are the human elements of risk; these include short
memories and the inclination to convince ourselves that we are experiencing
"innovation" and "creativity," when what is really
happening is a lowering of credit standards and increasing leverage.
- Human elements of risk also include optimism, gullibility,
longing to make easy profits, short-term focus, genuine belief in the
extrapolation of so-far successful speculation, group psychology or the
lemming effect, and in some cases, fraud.
- None of this is new. Today's sub-prime mortgage bust
displays the classic patterns of credit over-expansions as they have recurred
every decade or so for centuries. Such credit celebrations are based on
optimism and a euphoric belief in the ever-rising price of some asset
class, which in this most recent case includes houses and condominiums.
They typically entail the belief that the economy has changed in some
fundamental way, and that a "new era" is beginning. The euphoria
is inevitably followed, just as now, by a bad hangover of defaults, failures
and losses suffered by both the average Joe as well as financial professionals.
- The great British financial journalist Walter Bagehot
observed back in 1873: "The mercantile community will have been unusually
fortunate if during the period of rising prices it has not made great
mistakes. Such a period naturally excites the sanguine and the ardent;
they fancy the prosperity they see will last always."
- Nothing fundamental has changed about this in 134 years:
the huge amount of financial legislation in the meantime notwithstanding.
In the recent period of rapidly rising house prices, which seemed like
it would continue indefinitely, the sub-prime mortgage community, sanguine,
ardent, and enjoying success, made some significant mistakes, and further
excessive speculations will doubtless come to light. The current bust
will also reveal its own swindles and scandals, as have its many predecessors.
- Wall Street analysts and traders are now scrambling to
figure out who holds these risky assets. At the same time, as in the past,
the specter of political overreaction looms large. Will Congress address
this problem with a "Sarbanes-Oxley Act of Mortgage Finance"
or some similar punishing of the innocent along with the guilty? That
is one road better not taken.
- Mr. Pollock, a resident fellow at the American Enterprise
Institute, was president and chief executive officer of the Federal Home
Loan Bank of Chicago from 1991 to 2004.
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