The U.S. economy, and the stock market in particular, have been in a volatile up and down lately, stemming from the easy credit that permitted some borrowers to borrow more than they could afford to buy a home on the assumption that prices would always go up. See, e.g., the series of articles by Jeremy Peters and others in the last month's New York Times: Edmund Andrews & Jeremy Peters, Persistent Fear Drives Stocks Down, NY Times, Aug. 29, 2007; Jeremy Peters, What a difference a simple rate cut makes, NY Times, Aug. 18, 2007; Jeremy Peters and Louis Uichetelle, A Day of Wild Market Swings and Global Anxiety, NY Times, Aug. 17, 2007; Geraldine Fabrikant & Jeremy Peters, This Time Mutual Funds are Losers Too, NY Times, Aug. 14, 2007; Jeremy Peters, Stocks Tumble as French Banks React to Home Loan Worries, NYTimes, Aug. 10, 2007; Jeremy W. Peters and Wayne Arnold, Stocks are Volatile after Global Sell-Off, NYTimes, August 10, 2007. As rates increased on adjustable rate mortgages and borrowers realized that they could not pay or refinance, the credit crunch set in. Defaults and foreclosures are up, and sales are down, as more houses come on the market to depress sales in a vicious cycle, because people fear that prices will go down even more, later. Credit suddenly tightens beyond the housing markets, as commercial paper investors get finicky and big corporate deals get renegotiated. The stock and bond markets ricochet off every piece of news.
There are a number of interesting aspects to this crisis that I have been trying to think through, as each day's market assessment comes in. We have long claimed that we are helping Americans own their own homes through our tax policy for mortgage interest deduction, yet it functions as an upside-down subsidy since most Americans do not itemize and so cannot benefit from the deductions and most of the benefit of the deduction goes to Americans at the top of the income distribution who have mortgage loans at or beyond the maximum qualified amount. In the last twenty years, Wall Street has sung the praises of securitizations of mortgage loans--through real estate mortgage investment conduits (REMICs) and collateralized debt obligations (CDOs) and grantor trust securitizations--vehicles that provide the desired debt-for-tax characterization of the interests issued--that permit lenders to off-load the risk to a wide range of investors and use the proceeds of the securitizations to make new mortgage loans. But the weak side of those securitizations is showing in the current default climate. Homeowners cannot go down to their local bank and work out their mortgage loan--the loan has been sold to a sponsor who put together the securitization, and the loan is being serviced by a servicer with no connections to the homeowners' communities. Modifying a loan in a securitization vehicle may be harder to do. Banks who underwrote securitization vehicles and provided buy-back guarantees (probably thinking that such a time would never come to pass except on an acceptably small number of loans) may find themselves with substantial outlay requirements for loans they don't want. It seems that it is the little guy who is most likely to get really hurt by all this.
Take one example of the kind of riskier undertakings put in motion with the surge in CDO and REMIC deals. I'm thinking about the relatively new "guaranteed maturity class" created for REMIC securitizations, that effectively have a put right to a sponsor or other financial entity to buy the related mortgage loans for MORE THAN THE CURRENT FAIR MARKET VALUE in order to pay off the REMIC classes at the guaranteed maturity date. The big REMIC sponsors started doing those deals in 2000, even though I have always had my doubts that the buyback at less than market value was permitted under the REMIC rules for this purpose. Now some of those buybacks may be required, when the mortgage loans are worth less than expected.
Like the Long Term Capital Management Hedge Fund bailout, people have been talking about the need to help the big banks through this liquidity crunch caused by the softening housing markets and the subprime lending crisis. As New York Times op-ed writer James Grant reports in his August 26, 2007 editorial, The Fed's Subprime Solution, the "sheer size" of the CDO market is a shocker--$1 trillion. The other stunner is "[t]he shocking fragility of recently issued debt ....[with] alarming numbers of defaults despite high employment and reasonably strong economic growth." There have already been losses at big banks, and there will probably be more. And the credit markets are considered too weak to withstand the pressure. The Fed on August 17 lowered the discount rate it applies for direct loans to banks, to reassure them that the loose money period would continue. But Wall Street wants the Fed to come to the rescue of the big financial institutions (again) by reducing its federal funds rate. Grant's assessment is on the mark: one problem underlying our credit markets is "the notion that, while the risks inherent in the business of lending and borrowing should be finally borne by the public, the profits of that line of work should mainly accrue to the lenders and borrowers. It has not been lost on our Wall Street titans that the government is the reliable first responder to scenes of financial distress, or that there will always be enough paper dollars to go around to assist the very largest financial institutions." Ultimately, Grant concludes, having the Fed step in too readily to stop so-called 'bear' markets is a problem: "capitalism without financial failure is not capitalism at all, but a kind of socialism for the rich."