The financial markets are going nuts, and it will take time and some economic pain to make them sane again

The sub-prime mortgage industry crisis has claimed its first victim, American Home Mortgage, and now it’s setting its sights on another mortgage lender, Countrywide. I probably wouldn’t care, except that Countrywide is my mortgage company. I’ve got good credit, so I’m not worried about having a bankruptcy court call on the assets of my house if Countrywide were to fail, but even so, having my lender in distress is something I’d really rather not have to deal with.

What’s absolutely nuts about this, though, is that Countrywide isn’t a sub-prime lender. Countrywide is a full financial company, and the mortgage subsidiary has the backing of a bank with which to control risk and fund operations of the wider company. Over 90% of the mortgages that Countrywide handles are “prime” loans, not sub-prime. And yet Countrywide has been painted with the same brush as sub-prime lenders New Century and American Home Mortgage. Countrywide’s recent debt downgrading and stock price collapse are totally irrational.

Unfortunately, the financial markets have stopped being rational when it comes to the mortgage business, something that Washington Post commentator Sebastian Mallaby and WashPost/Newsweek commentator Robert J. Samuelson have both commented about recently.

Mr. Mallaby’s commentary today (A Market Run on Rationality) on the Countrywide debacle describes what we’re seeing in the mortgage section of the financial sector as a “panic”.

The most vivid image amid last week’s financial turmoil came from Calabasas, Calif., home to the nation’s biggest mortgage lender, Countrywide Financial Corp. At a retail branch down the street from Countrywide’s headquarters, depositors reportedly “besieged” a representative on Thursday, demanding to get their money out. The next day similar scenes played out at other Countrywide branches, conjuring those grainy black-and-white images of Depression-era bank runs. “I know a little about what happened in the 1930s,” one customer told Reuters. “It smells like it could be the same.”

These vignettes may have been swollen out of proportion by the journalistic magnifying glass, but they capture the essence of the moment. For the chaos in the markets has become as scary and as arbitrary as an old-fashioned bank run. Fear has taken over, and sound institutions are suffering along with poorly managed ones. It is a reminder that the markets are an exquisite instrument for pricing risk and allocating capital — except during those brief periods when they go stark raving nuts.

Mr. Mallaby posits that the panic is ongoing because the rational people in the stock and bond markets haven’t been able to borrow enough money to offset the crazies due to the credit crunch. If this is true, then the Fed’s actions last week indicating that they’ll accept higher inflation for a while if it stabilizes the financial markets and protects solid companies like Countrywide make a great deal of sense. After all, while the Fed’s job may to keep inflation down, as Mr. Mallaby says, it’s even more important to stop a panic by lending money to banks as a last resort.

Unfortunately, something that Mr. Samuelson said in his commentary (High Finance Roulette) makes me a little more nervous about the Fed’s ability to stall the panic than I would be otherwise. Mr. Samuelson points out that the economy of the U.S. is highly dependent on the health and rationality of the markets, yet there have been so many recent changes in how the market works that rationality may not even be possible.

Many subprime mortgages have gone into default. [Collateralized debt obligation security] investors are suffering losses. The credit cycle has reversed: Investors have retreated; credit standards have tightened; home buyers are scarcer; housing prices are dropping; it’s harder to borrow against home values; consumer spending is weakening. Whether this will cause a recession is unclear.

But it captures a larger dilemma. Capital markets are not just incidental to economic growth. They’re a force for both good and ill. The recent financial innovations have made it easier for countries, companies and individuals to borrow and tap investment capital. Many types of credit (auto loans, business loans) have been “securitized,” unlocking new sources of money. New financial institutions have flourished: “hedge funds,” pools of capital provided by pension funds and wealthy investors; “private equity” funds, with money from similar sources.

The peril is that so much has changed so quickly that no one knows how the system operates. It’s often roulette. Monday’s defensible investment may become Tuesday’s silly speculation. Global markets are interconnected, and financial conditions are tightening. Some hedge funds—including foreign funds—have suffered huge losses on U.S. subprime mortgages. These could harm banks that lent to hedge funds. Up to a point, losses are inevitable and desirable. They remind investors of risk. But too many losses—too much fear of the unknown—can trigger a chain reaction of selling and credit contraction. This must worry the Federal Reserve and other government central banks.

I find the statement “so much has changed so quickly that no one knows how the system operates” downright scary. We’ve trusted a significant portion of our economic health to a system that no-one really understands, and that’s never a good idea. And Mr. Samuelson is right – the Fed is worried, as Mr. Mallaby’s commentary pointed out.

Not only are we having our own financial market problems, but the U.S. has threatened to impose sanctions against China if they don’t allow their currency to trade in a wider range against the U.S. dollar (this is important because part of our trade deficit is a result of an artificially low trading value of the yuan to the dollar). In response, two Communist Party organizations suggested that China might respond by dumping some or all of the ~$1.3 trillion held by the Chinese government. This has added even more to market nervousness given that a dumping of currency onto the markets could cause a recession in the U.S. However, unlike the market panic regarding mortgage companies, it’s unlikely that China would actually dump their debt. After all, if they did so without freeing the yuan at the same time, the collapse of the dollar would suck the yuan down with it. And if dumping dollars caused a recession in the U.S., it could easily cause a recession in China’s economy as well. After all, trade with the U.S. accounts for 7.5% of China’s entire economy, while U.S. trade with China accounts for only 0.4% of the U.S. economy. Even former Fed Chairman Alan Greenspan says that China won’t dump dollars, although his reason isn’t one we should cheer about – China probably couldn’t find enough buyers.

So, we have a situation where the financial markets have changed so much recently that no-one really understands how they work any more, people are panicking and attacking financially-sound institutions like Countrywide instead of focusing exclusively on institutions that are actually unsound, and politicians both here in the U.S. and internationally are going out of their way to make things worse instead of better.

The only way out of this situation is to be patient, to make carefully considered and gradual changes, and let the markets and government(s) work together to restore rationality. This means putting a stop to ill-considered threats of trade sanctions out of Senate committees and the government shoring up financially-sound companies like Countrywide while allowing financially busted companies like American Home Mortgage to fail.

It also means that we all have to accept some personal economic pain, in the form of reduced 401k yields, stagnant or falling home prices, higher credit interest rates, etc. And when rationality does finally reassert itself, the economy will be better off for it.

Categories: Economy, Politics/Law/Government

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13 replies »

  1. I understand the logic – and the good sense – of your reasoning, here, Brian, but that doesn’t lessen the pain for some of us. I have a house in NC that has been on the market for 18 months and is now priced $40K below tax value – and I still can’t sell it. A lot of that has to do with potential buyers either being afraid to buy or unable to qualify because qualification has tightened so much so quickly.

    So telling me to be patient reaches my head, but it doesn’t make my heart ache and anger at the fast and loose playing of the system by the financial industry that put me in this mess any easier to bear….

  2. My wife and I technically made about $500 on our first house – if you negate the fact that we put something like $25,000 into it over the course of the 3 years we lived there (we put in the back yard, a deck and patio, a sprinkler system, and finished the entire basement). Since we left, my wife told me that the house is now worth about $15,000 LESS than what we sold it for, so I have some understanding of your pain.

    In addition, the problem with selling our last house was that we were surrounded by foreclosures and HUD homes that were WAY cheaper than our house was, and our location and improvements weren’t enough to compensate for the price differential. And all those cheaper homes were because of people who bought more home than they could afford, or bought on interest-only loans, or who got laid off when the economy went into recession after the tech bubble popped and 9/11.

    I’m not trying to say you shouldn’t be angry, but rather not to let your anger drive you into doing something rash like demanding the Fed lower interest rates a lot and fast (something that would bring on massive inflation) or selling just to get out of a house if you don’t financially have to.

    In fact, if you can contain your anger and direct it appropriately, it can actually serve you in this instance. It helps keep the pressure up on local, state, and federal government to rein in sub-prime mortgage regulations so that things don’t get as out of control as this ever again. Anger and pain can be great motivators for learning from our mistakes, something that we need to do from this particular correction.

  3. This is all driving me toward doing something rash like renting. If I could, I’d gladly let the damned house we own in NY go for a $10K loss just to be rid of the hassle and risk, but I fear these latest developments have even made that impossible.

  4. On a separate note, I wonder how many people in Utah (miners included) voted for the Republicans, who in turn made mine safety worse so the mine owner could make more money.

  5. As a consideration, you might try listing your property in Canada or other countries with good economies. BC and Alberta have had double-digit year-over-year growth. And in Vancouver, property is just outrageously priced because all the Asian influx of money that used to flow into the US, but not any longer.

  6. Cape Town’s property market has been illogical for many years. I rent an apartment for a quarter of the bond repayments if I bought it.

    Your comment on banks being hit even though they don’t lend to the sub-prime market is indicative of the overall problem. Hedge-funds bought up the sub-prime debts via Collateralised Debt Obligations (CDOs) sold on the open market. These CDOs were rated by various agencies and the funds borrowed money on the strength of these ratings. From banks who don’t do sub-prime lending, like Countrywide.

    And that’s why the market is running in terror. No-one is sure who bought what and what liabilities this exposes them to. Yes, it is Darwinian. Yes, there will be pain. But, as I’ve said before, hopefully we all learn from this and don’t do it again.

  7. Unfortunately, given everything from the Great Depression to the S&L bailout of the late ’80s is any indication, we never learn. We just find new avenues to loot and plunder, then beg for bailouts while the people who bought into the myth have to live with the consequences.

    The bank run on Countrywide gave a lot of people jitters, but now the layoffs are beginning:

    What’s significant about those layoffs is that they are in the company’s “Alt-A” designation, which is better than subprime but not quite prime. “Alt-A” mortgages usually consist of those massive $400,000-plus McMansions (especially common out here in the DC/VA area) that are too big to be insured by Fannie and Freddie. This has already gone well beyond the subprime sector and is now threatening to engulf even the most seemingly stable mortgage originators–like yours. 🙂

    Don’t worry, though, because your mortgage lender’s CEO still stands to make out like a bandit even if the company’s stock fails:

    So while I have cautious optimism that this will get better, history does not offer much in the way of comfort. But at least housing in the coming years will be cheap for us potential buyers! 🙂

  8. Martin, that was the point many analysts are making “then beg for bailouts while the people who bought into the myth have to live with the consequences”.

    There must be NO bailouts to the companies that created the problem. Let them fail. Otherwise companies learn (like with S&L) that government – like a concerned parent – will always bail them out of taking responsibility for their errors.

  9. Gavin, I agree with you. But as I said, history does not leave me much room for hope that governments will leave the markets alone on this one. I fear that any potential bailout will be the worst of both worlds–capital infusions and rate cuts to support distended lenders, while the borrowers twist in the winds and end up in foreclosure.

    I’d much rather see laws passed that limit predatory lending and mandate financial education for borrowers than I would pumping more fake money into the system to prop up over-leveraged hedge fund managers.

  10. Well Bernanke has already cut rates once. Let’s see if he does it again. Given the deficit and partisan fighting in congress (which, I see, by some mystery has even lower popularity ratings than GWB – how’s that possible?) I can’t see how any agreement could come through on bailouts – or any other legislation – before the market rectifies itself…