Gaining From the Subprime Meltdown?
Kurt Brouwer August 14th, 2007
As we slog forward, mired in the morass of the subprime meltdown, we see a ray or two of light, hope and even historical perspective. Writing in the Washington Post, Sebastian Mallaby, points out in this column that we have seen many similar cycles before [emphasis added]:
‘The meltdown in financial markets may seem scary or mysterious, but it’s part of a time-honored story. In Chapter One, a new financial instrument makes capital available to a new class of borrower, and the result is profits for the innovator along with gains for consumers. In Chapter Two, a group of not-so-smart investors misunderstands the novel instrument and bids its price up too enthusiastically; when the inevitable bust follows, the innovation is denounced as inherently dangerous. Then, in Chapter Three, the complaints blow over. The not-so-smart investors learn their lesson and the new instrument stabilizes. Financial innovation turns out to be beneficial without being scary, but by that time another newfangled instrument has emerged to frighten people, and finance is hauled before the court of public opinion — again…
Mr. Mallaby has it exactly right. Our capitalist system periodically does go to extremes or excesses. And, for every boom, there is usually a bit of a bust. But the net result is that the innovation has been tamed and adds value.
For example, two innovations (junk bonds and leveraged buyouts (LBOs) together helped transform many formerly-stodgy American companies. Of course, the leveraged buyout artists of the 1980s went to extremes, but corporate leaders recognized that if they did not maximize value, they could be replaced quite easily after a buyout. As a result, American corporations became better-run, more efficient and much more profitable.
High yield or junk bonds first came into prominence as the financing vehicle for LBOs. Over time, they went through a similar cycle in which they were used, abused and ultimately adopted as a modest component of the overall financial market structure.
Mallaby closes with this comforting paragraph:
‘…But whatever the immediate turmoil, the eventual conclusion to the subprime story seems reasonably clear. When the dust settles, investors will have learned not to put blind trust in rating agencies, which are paid by bond issuers and so have an incentive to exaggerate how safe bonds are. And when the dust settles, the market for subprime mortgages will revive and thrive in dull obscurity. With financial innovation, it was ever so.’
This is a neat and elegant treatment of this process. New financial strategy achieves a goal and is very successful. Given Wall Street’s ‘too much is not enough’ mentality, the new innovative strategy gets used, abused and overused. Financial losses ensue and, with new-found wisdom and restraint, investors learn that the new strategy is merely another tool, not a panacea.
Hat tip: Brothersjuddblog
- Hedge Funds , Investing , Personal Finance
- Comments(3)
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Kurt,
I really appreciate your blogging.
Do you think that that some of the lasting innovations also include the securitization of loans and the bundling of asset-backed securities into CDOs with their three tranches? It seems that the yields from the CDOs in a friendly climate were lucrative and enticing.
A CDO with an “arbitrage-motivation” is an enticing way to get a high yield and also potentially a way to get confused about exactly how much one is exposed to risk.
It looks like a lot of CDOs were highly rated because their senior tranches were lower yielding and less risky. And their risky tranches were delivering great returns.
Do you think that some of these institutions that were purchasing CDOs were not bothering to contemplate their degree of exposure, or were they merely getting used to getting good returns in a good climate, and then using these instruments more and more?
These instruments are pretty darn clever ways of “spreading risk” and will surely be around after this mess is over, but one supposes that purchasers will calculate the risk versus reward a little more closely?
Ed–Yes. I think securitization is here to stay. The actual details of how loans are bundled will change no doubt, but the process will remain.
Reasons for investors losing sight of risk are 1) We were in a benign environment; 2) The buyers were far away from the actual bricks and mortar (or sheetrock) underlying the loan; and 3) They relied too much on computer models and not enough on common sense.
Risk has again become a four-leter word in banks from Brooklyn to Berlin. Long may it last.
It is so interesting going back to read these posts from the past.
We are now in a situation where we have approximately 21% of all buyers effectively out of the market. 21% is the number of Alt-A and Subprime borrowers who will no longer be able to get a loan. http://www.irvinehousingblog.com/blog/comments/why-the-sub-prime-meltdown-is-a-problem/
With 12 months of housing inventory for sale and 21% of the demand gone we’re actually looking at 15 months of inventory. Add to that the decline in the value of existing homes http://www2.standardandpoors.com/spf/pdf/index/CSHomePrice_Release_082653.pdf and you can see we have a serious problem. The decline in home values is a long way from over. We’ll need to work through that inventory but who is going to buy the inventory when they can’t get a loan.
To add fuel to the fire, the ARMs, Hybrid ARMs etc. that were written during the boom won’t finish adjusting until 2012. We still have a long way to go before we’ve seen the end of the massive quantities foreclosures.
But wait, the bad news continues. We are now looking at a situation where everyone who purchased a home in the last 2 years, and put less than 20% down, owes more than their home is worth. What is the incentive for those people to hang onto those homes? Have you heard of ‘jingle-mail’ that’s when you send the keys back to the lender in the mail.
There was an excellent article in the 10/2/08 WSJ with quotes from all the democrats - Barney Frank, Chris Dodd, Maxine Waters etc etc etc defending Fan & Fred saying there isn’t a problem, they’ve hit their goals. The regulators are saying this isn’t a question of goals it is a question of leverage - 100 to 1. Alan Greenspan weighed in and warned of impending doom and it all fell on deaf ears. It has recently been revealed that the staunchest defenders of Fan & Fred got huge political contributions from Fan & fred. It’s time for an independent investigation into the link between the $ and the defenders of Fan & Fred. Even after Raines and the gang cooked the books for bonuses and got caught they simply ignored the many signs of trouble.