Resident Fellow Alex J. Pollock

At the IUHF World Congress a year ago, we had a lively discussion of housing bubbles and related mortgage finance issues. With regard to the US case, the pessimists among us (including me) pointed out that a particularly troubling factor was that the subprime mortgage boom, an important contributor to the house price boom, was financed with tranched, senior-subordinated structured bonds made out of high risk loans.

These bonds were structured based on the models of the credit rating agencies. Their resulting junior tranches, sold to yield hungry investors, were and are highly leveraged to credit losses being worse than the models expected. When in addition the junior tranches of subprime securitizations were bought by some investors with financial leverage, using repurchase agreements or commercial paper funding, they became hyper-leveraged to reality being worse than the modeled expectations.

It is now apparent that reality is indeed worse than these expectations and that the pessimists were right. As Moore's Law of Finance states, "The model works until it doesn't." (Basel II theorists, please note!)

A sobering element of this problem is that the models include house price appreciation ("HPA" in the trade jargon) as a factor. One investment manager recently reported that his firm asked a credit rating agency what would happen if HPA were a negative 1% or 2% a year for an extended period of time. They responded that "their models would break down."

More than 80 subprime lenders have gone out of business since December last year, and other major lenders are cutting back drastically on subprime lending (a little late), raising credit standards generally, and raising jumbo mortgage rates. All of this reduces the availability of mortgage credit, especially for the marginal borrower, and reduces the demand for houses. Simultaneously, major homebuilding companies are reporting large losses and pessimistic outlooks, as house sales have dropped steeply and the for-sale inventories of new houses, existing houses and condominiums are all high.

It is evident that adding together an excess supply of houses plus reduced demand equals of trend of falling house prices. The S&P/Case-Shiller national US house price index has just reported a drop of over 3% for the second quarter of 2007, compared to the year earlier

Falling house prices tend to cause higher mortgage defaults, especially if loans were made, as they were, with small or no down payments. So the US appears to have entered a cycle in which defaults on mortgages (and securities made of mortgages) cause tightening credit, which helps induce falling house prices, which cause more defaults, further credit tightening, lower house prices . . . and so on, not forever, but for a while. The CEO of Countrywide Financial, a top mortgage lender now itself experiencing financing stress, recently expressed the view that the US housing sector will not recover until 2009.

At the World Congress, we were saying that we know these risky subprime structured securities are being sold and moved around the market, but where did they go? Who's got them? Who's got the risk? Now some of the answers are being revealed.

In this context, consider the 1873 financial classic, Lombard Street, in which Walter Bagehot made the following timelessly true observations:

• "The mercantile community will have been unusually fortunate if during the period of rising prices it has not made great mistakes."
• "Every great crisis reveals the excessive speculations of many houses which no one before suspected."

Now it is easy to see that the great rise in American house prices, both fueled by and inducing the great expansion of securitized mortgage credit, did indeed produce great mistakes, not only in the US, but on an international basis.

The financial houses now seen to have engaged in excessive speculations include not only the scores of failed subprime lenders, but some US hedge funds and investment banks which sponsor them, German banks, French mutual funds, British hedge funds, Chinese banks, Australian investment funds, and an investment fund listed in Amsterdam. Doubtless others will come to light.

We will probably see instances of Stanton's Law: "Risk tends to migrate to the hands least competent to manage it." But this risk has already burned some very competent and sophisticated hands, too. What else will be revealed?

The uncertainty of not being sure who is or isn't broke or financially wounded is a classic cause of a liquidity crunch, as has been experienced in August in international credit markets.

The fear is increased by the great uncertainty about the value of the subprime securities both to investors in funds and to lenders as collateral. How can they be marked to market when there is no active market? What does value mean when there are no or very few bids? Should mark-to-market portfolios be marked to fire sale prices? What happens if everybody does that at the same time? These are hard questions to which the answers are not clear. The result is to make everyone conservative at once, just as before they were generally optimistic.

It is instructive to look back to some of the optimistic forecasts of the past, all of which proved wrong.

A year ago, it was common to say that while house prices could fall on a regional basis, they could not on a national basis, because that had not happened in the large US market since the Great Depression of the 1930s. Well, now house prices are falling on a national basis, as noted above.

Early in 2007, people were saying that it looked like the housing market was bottoming and showing signs of stabilizing. Nope.

As the subprime bust grew worse, there were many assurances that the problems were "contained," without wider financial or economic effects. As late as August 1, the US Secretary of the Treasury reiterated that the market impact of the subprime problems was "contained." Obviously, this was not a good call, either. It also demonstrates Moore's Second Law of Finance: "The market is liquid until it isn't."

In September, the Congress will return to Washington after its summer recess. There is no doubt that the subprime and housing bust, the problems of the mortgage market and the wider credit crunch, rising foreclosures and the search for the guilty will generate much discussion, hearings, the introduction of numerous bills, and a strong political desire to Do Something. Aspiring candidates for the presidency are already putting forth such proposals and it is clear this will be an important political issue.

As I discussed in the June IUHF Newsletter, the one thing I believe should definitely be enacted, whatever else is done or not done, is a requirement for a simple, clear one-page disclosure to borrowers of the basic facts most important to them about their mortgage loan (PDF). This is both the best way for them to be able to protect themselves and a way to achieve a more efficient market.

This requirement has been introduced into the House of Representatives--it is contained in Title II of bill HR 3012.We'll see what happens during the fall. In general, the pessimists on the US housing and mortgage finance bubble all along, who have been proven correct by events, were those of us who study history. All the elements of the bust display the classic patterns of recurring asset bubbles based on credit overexpansions. Such credit celebrations are based on a euphoric belief that the price of some asset class--in this case, houses and condominiums--must always rise.

Now we are enmeshed in the inevitable subsequent hangover of defaults, failures, discovery of excessive speculations, dispossession of unwise borrowers, revelations of fraud and scandals, late cycle political reactions or overreactions, and credit contraction.

Many pronouncements will be made that "this must not happen again." But of course it will.

Alex J. Pollock is a resident fellow at AEI.