Fear and greed: why the American housing credit crisis is worse than you think

International Economy, The, Spring, 2007 by Lawrence B. Lindsey

As word gets around that actual default rates in the bundled pools of mortgages are higher than what the statistical models said they were, buyers of the mortgage pools begin to pull back from the market. One of the reactions to this has been to create ever-new financial products that supposedly parse out the risk of holding mortgages more carefully, giving higher yields to those who assume more risk and more normal yields in supposedly lower-risk products. One of these products is called a Collateralized Debt Obligation (CDO) that is really nothing more than a leveraged bet on a bundled pool of bundled pools of underlying mortgages. In a sign that we have entered the silly season, there is now a new product called a CDO-squared which is actually a bundled pool of CDOs, which of course themselves are simply bundled pools of bundled pools. This has caused words to take on new, and perhaps perverse, meanings. For example, there is a so-called "equity tranche" in these CDOs that has a very high yield--40 percent or more--due to the high leverage involved. Buyers of these products actually probably expected to lose their entire equity position. But if the product just stays around for a few years, they will have made a huge return nonetheless.

The details of this process are relatively unimportant. The important points are two-fold. First, the ultimate lenders or people who have money at risk in the home mortgage market have virtually no direct knowledge of the actual collateral that lies behind their financial product. Second, the leverage on that collateral that is always inherent in a mortgage has, in turn, been leveraged several times over in the process of creating financial products with very large returns that the market would buy.

This leaves the mortgage market somewhat vulnerable. Originators are now largely detached from institutions that can actually keep mortgages on their own books. So a breakdown in this process of creating mortgage-backed securities could have profound ripple effects on the availability of mortgages generally. The leverage in the system coupled with the widespread diffusion of the underlying assets increases the likelihood that if something goes wrong, even in a fairly limited market, the effects could be nationwide.

HOW WE ALL COULD LIVE HAPPILY EVER AFTER, SORT OF

Since long before Walter Bagehot wrote his ideas in The Economist, credit cycles like the one that we now confront in housing have been part of the economic picture. They are fundamentally about fear and greed, and we won't repeal credit cycles until we change these very human emotions. The totalitarian ideologies that developed in the twentieth century thought they could do this, but all they did was substitute the mood swings of the megalomaniac in charge or the internal machinations of the Politburo for the functioning of markets. Today few would argue that imperfect as they are, markets are less dangerous.

Bagehot's insight was that fear and greed could also be harnessed to force market participants to clean up the excesses of the credit cycle themselves. Credit cycles become truly dangerous when fear gets so excessive that markets break down completely. When no loans are being made, the price of the underlying assets being bought and sold drops precipitously and even relatively good credits with low risks become insolvent. The solution is to let the market function but nudge it to gradually reduce the risks in the system. The best way to make market participants do this is to make the cost of the credit that is underpinning the system slightly more expensive while still making it available so that buyers and sellers can still make their transactions.