Alex J. Pollock
The issues run far beyond the failure of specialist subprime mortgage lenders because the boom was financed with tranched, senior-subordinated structured bonds, based on the models of the rating agencies and sold to yield-hungry investors. The junior tranches of subprime mortgage-backed securities and collateralised debt obligations are highly leveraged to credit losses being worse than the models expected.
Where this risk has migrated, just who is holding these risky tranches, how will they mark them to market when there are few or no bids, and who will buy any more such tranches as the bust proceeds, are questions traders and analysts must now scramble to answer.
Moreover, since "the implosion of an asset price bubble always leads to the discovery of fraud and swindles," as economic historian Charles Kindleberger so rightly observed, subprime mortgage scandals and lawsuits are forthcoming. This will, as it always does, stoke the already heated feeling of the politicians that they have to Do Something. As an old banking colleague once told me: "There is nothing new in finance, only cyclical recurrence."
Alex J. Pollock is a resident fellow at AEI.