Subprime Fallout: Few New Lessons

♠ Posted by Emmanuel in at 8/10/2007 01:33:00 PM
I've been watching a lot of Bloomberg TV over the past two days and have thus been bombarded by countless hours of programming on subprime shenanigans. On today's show, they even brought out Marc Faber--Mr. Gloom, Doom, and Boom himself--and one of the four horsemen of financial apocalypse (also add Jim Rogers, Bill Fleckenstein, and newbie Nouriel Roubini). As a pretty bearish person myself at the moment, I must say there's very little left to add to this story. Still, it's good to list down one's thoughts to get things straightened out.

My contention here is that the subprime contagion, crisis, mess, or whatever you call it offer few new insights. I will try to offer things in a slightly different, political science perspective. While economists focus on finding sources of market failure and businesspersons try to make money in spite of a market downturn, political science types are more interested in finding appropriate policy measures that can lessen the frequency of such boom-bust cycles and mitigate their harshness. It is said that political science people think more like historians than economists or businesspeople. So, without further ado, here are ten non-findings about subprime conditioned through the lens of history. Starting from the most obvious non-findings...

(1) It's generally a bad idea to lend to those who'll have trouble repaying their debts.
Lax underwriting standards exemplified by so-called NINJA loans (to those with No Income, No Jobs or Assets) eventually backfire on lenders.

(2) Financial alchemy cannot turn junk into gold.
All these structured finance products such as CDOs, CMOs, CLOs, C3POs, R2D2s, and many more sorts of Star Wars droid-inspired derivatives have been promoted as ways to render the credit risks relatively risk-free. But, when push comes to shove such as now, the reality is once again revealed. These relatively illiquid instruments, which cannot be "marked to market" as there is often no comparable "market" for them, have to be "marked to model" according to arcane financial simulations. Unfortunately, fanciful scenarios abound in "mark to model" land that portray things as being more hunky-dory than they really are, but things have a way of literally crashing back to reality.

(3) There is no magical new economic paradigm at hand.
Dow Jones 36,000 or the end of risk--take your pick. People keen on deluding themselves and others and will spin these stories about markets that keep climbing forever because valuation models are no longer relevant or risk is no longer a major consideration as demonstrated by wafer-thin credit spreads, yadda-yadda.

(4) When America catches a cold, the rest of the world sneezes.
With a one-trick pony global economy largely predicated on US consumer demand, how could it be otherwise? Decoupling scenarios aren't bound to work when the rest of the world does most of the exporting and America most of the importing; when the latter slows, the former will slow in response. Unless global economic imbalances become less extreme, this story will hold.

(5) America's negative savings rate does matter.
For over twenty-four consecutive months now (two years), the US personal savings rate has been less than zero. Some commentators say this lack of savings "doesn't matter" because it doesn't take into account the rapid price appreciation of stocks and housing held by Americans.

To make ends meet given a negative savings rate, households will need to do one of three things: borrow even more, sell off assets, or run down their savings. The first option is becoming less feasible as home equity withdrawals which have sustained a lot of consumer spending stateside are going the way of the dodo. Nor are these consumers likely to find a ready marketplace should they decide to liquidate their stocks in a tanking equity market or houses in a DOA housing market These holdings of wealth cannot be readily tapped. As for savings, how long will Joe Average have any real savings when dissavings have been going on for so long?

(6) Central Banks bail out their own.
The ECB's decision to flood Euroland with another 65 billion euro today after supplying 95 billion the day before demonstrates that national interests will trump considerations of "moral hazard." Banks may act too boldly by engaging in all sorts of derivative hanky-panky in the belief that the central bank will bail them out when things go wrong, bigtime. As France's largest financial concern, BNP-Paribas has not been allowed to take too harsh a medicine. It's Marxist base-superstructure all over again: the political-economic superstructure of central banking will, ultimately, protect their own economic interests such as those of BNP-Paribas.

(7) Politicians will not hesitate to use taxpayers' money to secure political gain.
Senators Hillary Clinton and Chris Dodd have been keen on writing legislation that would make government-sponsored enterprises Fannie Mae and Freddie Mac mop up the "toxic waste" leaking out of the subprime contagion. This move would undoubtedly be politically popular, but it would come at a steep price of saddling these enterprises with low-quality assets. Unsurprisingly, both Dodd and Clinton are running for the highest office in the land. Moreover, there is little doubt who would ultimately have to pay the price for supporting those who've run into credit problems--taxpayers, of course.

(8) Competent market regulation is necessary. The public sector lacks the glamor of its private sector equivalent. Yet, the public sector is often blamed for not calling out the excesses of private sector activity such as the subprime mess in advance until things boil over. While hard-core libertarians would still prefer less regulation, whatever its eventual costs to the public, most sensible people would opt for competent officials with a keen eye for upcoming trouble wielding a set of effective policy tools to clamp down on excess speculative fervor. Therefore, public sector counterparts of those making newfangled speculative machinations have to be near or on par capability-wise. How to attract talented people to government posts becomes a real challenge: Do some value public service as much as private gain? One would hope so.

(9) Efficient markets theory is just textbook fodder
When greed gives way to fear, long-term valuations don't change all that much--people do as they panic in a race for the exits.

(10) The more leveraged they are, the harder they fall.
This point is clear for the stakes are magnified when leverage is used in copious amounts. You can win more, but conversely you can also lose more. Whether governments do the right thing and allow financial concerns to take their just desserts is another matter. These concerns are often let alone to make profits on the way up, but are shielded from their own excesses on the way down. Greenspan put, anyone, or today's equivalent--the purported Fannie Mae /Freddie Mac call"? Whether financial concerns that have behaved badly will be issued yet another "get out of jail free" card is still in the offing.