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Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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July 26, 2007

It Never Was Just Subprime

So now the dissecting of today's market jitters begins, and there is no shortage of diagnoses. Today's data releases -- described here, here, and here, for example -- were certainly not great, but the most popular explanation seems to be that market players have developed a newly found sense that the world is a risky place.  Barry Ritholtz sums it up nicely:

The Dow is off 395 points as I type this. There will be some short covering shortly, and a rally attempt. But what I want to address is the change that has taken place:

What has changed? What is different today than yesterday? Are the prospects of the economy and/or corporate profits so different today than they were merely a week ago?

What has changed is Credit: Risk appetite for anything less than AAA -- and that includes the ABX stretched definition of AAA (see WTF is going on in the ABX Markets?) -- has waned considerably.

The tinder, if not the spark, for the flare-up of credit concerns was this week's revelation from the mortgage lender Countrywide Financial that loan problems extend well beyond the subprime borrower.  From the Wall Street Journal (page C1 of the July 25 print edition):

By laying the blame for its earnings shortfall on rising defaults of prime home-equity loans -- many taken out by people who were straining to afford a house and didn't fully document their income -- Countrywide undermined the popular notion that only subprime borrowers are falling behind. And that could have a broad, negative impact on lenders' stocks.

And from from Joanna Ossinger's column at the WSJ Online:

Credit-market woes are partially rooted in the subprime-mortgage sector, which has been a source of market angst for months. But recently the problems have become more acute, as hedge funds invested in mortgage-backed securities have struggled and as default rates have risen, even among prime borrowers. Banks have been hurt by having to take loans onto their balance sheets instead of passing them on to outside investors. And major private-equity acquisitions have struggled to find financing, possibly removing one long-standing support for the market.

It "all goes back to weakness in the mortgages," said Larry Peruzzi, equity trader at Boston Company Asset Management.

But a closer look at the Countrywide development is instructive, as it reveals that the source of the problem is, not surprisingly, non-conventional types of loans.  Again from the WSJ article:

Many of the home-equity loans that are going bad are "piggyback" loans to borrowers who took out a second mortgage because they couldn't afford a large down payment and didn't want to pay for mortgage insurance.

Now, with home prices falling in many areas, some borrowers owe more than their houses are worth. That is forcing Countrywide and others to increase provisions against losses.

Another concern is the $27.78 billion of pay option adjustable-rate mortgages held on the books of Countrywide's banking arm. These loans allow borrowers to pay no principal or less than full interest each month. If they choose that option, their loan balance grows. Payments are now overdue on 5.7% of these loans held by Countrywide, up from 1.6% a year earlier.

But here's the thing -- we surely have known for a while now that the building stress in mortgage markets is not a prime vs. subprime thing, but conventional-loan vs. non-conventional loan thing:




What seems like fresher news to me is the growing skittishness in credit markets that are not so clearly associated with the housing sector.  From the Financial Times:

Stock prices plunged on Thursday amid a flight from risky credits and fears about banks’ growing exposure to leveraged buy-out debts...

Investment bank stocks led the market lower on worries that they will have to use their balance sheets to fund private equity deals. The S&P investment bank index was down 5.3 per cent.

Concerns about the possibility of a credit contraction were exacerbated this week when banks gave up attempts to sell to investors $20bn of debt for the leveraged buy-outs of Chrysler and Alliance Boots, the UK retailer.

A Financial Times analysis shows that in recent weeks, bank balance sheets have absorbed more than $40bn of high-yield debt for buy-out deals that was meant to be sold to investors.

So you have your pick -- weak economic news, a broadening of housing market woes, a fading corporate debt market.  Or just choose all of the above and keep your fingers crossed that it's only a bad week and not a perfect storm.

July 26, 2007 in Housing | Permalink


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Perhaps a time for reflection:
The risk is that banks can't sell off the loans that they've made?

Gosh.. I remember way back ...when banks actually made loans on their own books..

Its as though people are wondering.. gee where will the banks get that money to make the loan if they don't sell it??

What was a newfangled "derivative" 5 years ago is no so integral to the banking system.. that we can't even remember what banks were supposed to do...

Posted by: stan jonas | July 27, 2007 at 10:46 AM

We operate SellHomeHouse.com, a home selling site and have seen a huge increase in the number of motivated sellers in the past few months. With how many homes are on the market right now so many are having a hard time selling their homes, and are going to great lengths to sell their homes. Hopefully the market will turn around next spring as predicted so sellers have an easier time in 2008!

Posted by: TSmith | July 27, 2007 at 11:41 AM

in the last few day's we're seeing motivated sellers of stock...

but why should anyone care whether they have an easier time of it in 2008...

Perhaps we should average down in Housing too?

Posted by: phyron | July 27, 2007 at 12:07 PM

Good start Mike on a great topic, but it's clear now it IS a perfect storm, one that started gathering force back in the 90s and whose force was not an accidental culmination of unforseen circumstances.

First, FED head A. Greenspan pushed Congress to DRAMATICALLY define down inflation. (Boskin Commission recommendations over those of K. Abraham, the head of the BLS.)
Then, Congress, again following the lead of AG, TOTALLY repealed Glass-Steagall WITHOUT calling for single-body regulatory control over the resulting financial (banking/Brokerage) sector.
Let's not forget the impact on soon to be retiring boomers of Congress' 1997 $500,000 homeowners tax exclusion.
The Bush Administration added gale-like strength to the growing storm with its "ownership society". (How many programs were instituted to advance home lending to those previously determined by free-market processes to be unqualified?)
Fannie & Freddie correctly assessed the opportunity and whirled it into a full-force tornado. (They buy almost 50% of residential mortgages. Had they simply decreed they wanted no part of the scam UNLESS a deep pockets guaranteed the no-doc, no down absurdly risky loans, the storm would've topped out as subtropical at best.)
The last and greatest culprit in creating the perfect storm was the FED. Forget any simplistic explanation that it kept "low interest rates for too long", that's sophomoric. The FED alone is responsible for this perfect storm as it lead the fight for conditions needed, resused to interced when it could have stopped it and along the way provided legitimacy for it with its rhetoric.
Let's review. The FED set the atmospheric conditions by defining down inflation close to a whopping 25% (4+% to 3+%). Dean Baker ably argued (1996?) it was unreasonable to not assume other effects. Then, without explanation, the FED stopped looking at M3 - the monetary measurement that most closely tracked prior readings of inflation growth. The FED never would've been able to justify the extended period it printed so much money had it not first changed the rules.
But, the FED did more. It narrowly (and incorrectly) interpreted its supervisoral role over the mortgage lending process to its direct role of overseeing its Banks' lending policies. Guess what? The percentage of non-bank originations (& non-traditional mortgage loans) skyrocketed!
A cynic might conlude it didn't hurt BB's chances to land his FED Chairmanship appointment when he announced in 2005 that housing prices were being "driven by fundamentals". It's informative that BB never mia culpa'd on the origins of the housing bubble, he just changed his line along the way. By the time he acknowledged the problem the storm was unavoidable. Even a casual observer would now conclude the FED's role in the oncoming catastrophy was causitive. Skeptics need only look at the FED's toothless nontraditional mortgage "guidelines" issued in the fall of 2006. Instead of stating clearly, STOP THIS NONSENSE - NOW, the FED signaled the r.e. industry time to start unwinding the scam. So, here we are a year later, facing the struggle no one wanted to face last year.

You betcha, it was a perfect storm. But, let's be clear about who the driving forces were.

Posted by: bailey | July 27, 2007 at 12:34 PM

We can all look back to see the structural imbalances in the financial systems, domestic and global, these are obvious. These imbalances have created vapors of weath across the globe that have presented themselves in many forms... Wealth effects from housing, corporate earnings, employment statistics, global trade, inflation assesment, consumer vitality, etc.etc, I could go on and on, have manifested themselves in the most excessive aquisiton binge in human history. It is imppossible to place the blame on anyone as this was a collective event that occured right in fron of our eyes. It was a human event in which everyone played a role. We are all driven by self interests and we closely watch our neighbors and judge them by standards not of our own making.

A new dawn is breaking on the horizon as I write this and it is clearing away the fog, the bars are closed, the vampires, rats and cockroaches are scurrying for cover. Many who had not been invited to previous parties and lack the experience, have over indulged in the exhilirating novelty of wealth and aquisition, a few more than others. It is still very early in the morning and some of us will sleep off our hangovers to face the recriminations later in the day. Some will want to keep the party going, but the novelty has turned mundane.

As the sun rises the vapors of illussion will melt into a reality of our own making. And just as we are seeing the housing bubble deflate in front of our own eyes, so too shall the consumer, equities, coporate earnings and employment, just to mention a few. These will canibalize each other. Where is the buyer of last resort....?


Posted by: ECONOMISTA NON GRATA | July 29, 2007 at 11:23 AM

I think everyone here underestimates the power of the market. Bear Stearns had a couple of funds go bust, but the market somehow knew it was deeper than that.

What needs to happen is that all the information on how far the sub prime thing stretches needs to come out. Once the market has all the information, it can make a rational decision.

Tricky lawyers and CFO's are trying to contain the information, and parcel it out to see how much damage they can control.

I disagree with Bailey's analysis that it was all the feds fault in the late 90's. It is impossible to forecast ten years ahead of time.

Home ownership is a desirable standard for people. It gives them a stable foundation to direct their life. Banks made bad decisions on lending, and should pay the price for it.

Given all the shocks to the economy in the past 7 years, the FED has done a pretty good job. Let the capital markets work, and keep government regulation and bail outs out of the market. If some banks lose a bunch of money and go bust, it's a god thing. Part of being in a capitalistic society.

Posted by: jeff | July 29, 2007 at 12:01 PM

Most financial institutions have a notion of the overall level of risk they are willing to hold. They hold lots of assets of varying risks, and may hold various portfolios each of which has a different target level of risk, but in the end, banks cannot accept a run-up in risk in a major asset class without adjusting. When CDOs and the like began to crumble, the implication that overall risk held by financial institutions was up, and had to be brought down. Shedding assets that had become high-profile as "the problem" was unlikely to do the whole job, so other risky assets had to be disposed of, too.

Back in late 1990s, we say contagion go from mis-matches in currencies (borrow dollars, earn baht) to portfolio problems - dump emerging market assets. Portfolios that held no Thai assets still got whacked.

Contagion today starts from a different place, but the mechanism is the same. Whatever is in the portfolio that holds CDOs is likely to come under pressure, with the riskiest holdings going first - gotta fix the risk profile. Next is portfolios that didn't hold CDOs, but see their risk go up as leveraged loans begin to widen out.

Posted by: kharris | July 30, 2007 at 09:42 AM

I agree on most of what you had to say. If I may add that the new FHA bill passed by congress and signed by the president should help a lot of distressed homeowners

Posted by: Mortgage advice expert | August 14, 2008 at 06:17 AM

The new mortgage reforms will definitely have a significant impact on the housing market because many prospective homeowners will not be able to meet the stringent income to mortgage payment ratio of 28% and heftier down payments. As a result we will see more renters.

Posted by: Gmac Mortgage | June 17, 2011 at 12:57 PM

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