Containing Financial Contagion at the Source

The Problem, A Flawed Assumption With Flawed Methods

The world financial market is currently in turmoil because of the recent housing and credit crisis. From January to November 2007, more than 1 million homes in the United States entered foreclosure. Not only are homeowners losing their homes, but paying renters are being evicted as lenders reclaim properties. Depending on the state, 48–69% of foreclosed loans come from the subprime market. Subprime refers not to interest rates but to borrower quality, determined by low credit scores, little credit history, or unstable income with limited assets. Because of the increased risk associated with loaning to them, those borrowers cannot get favorable rates and often take out loans with short-term introductory rates. These loans generally get packaged by Wall Street into residential-backed securities and structured into slices or tranches that can be priced and rated from AAA to BBB– on the basis of the credit risk inherent in each tranche. When these mortgages adjust to market rates, the borrower no longer qualifies for the existing loan and can no longer pay it back. Because techniques such as gifted down payments and no requirements to prove income were the only way to move these borrowers into mortgages, many were lured into a false sense of prosperity for which they were neither prepared nor equipped and for which they are now suffering through foreclosure.

The subprime mortgage market bubble eventually led to a credit crunch, causing a chain reaction in which the twin engines of America’s credit system—the capital markets and banks—both misfired. A recent U.S. banks report suggests that bank failures could rise beyond historical norms (Pimlott et al., 2008). The resulting effect has spread from Wall Street to the broader economy. If the International Monetary Fund is correct, the resulting credit crash could be the most expensive in history, measured in dollar terms at $945 billion (Guha, 2008; Strauss, 2008). The impact is so devastating that pressing questions arise: How might we avoid such credit crashes or contain the spread of credit crises at their source?

Although credit crashes do not emerge randomly, the core of the problem lies with misjudgments by the investment community (Greenspan, 2008). Many researchers believe that three trends have conspired to create the recent credit crash: First, residential mortgages, leveraged buyouts, and other loans have gravitated away from banks toward global capital markets. Subprime mortgage-based securities appear underpriced at their original issuance, which allows banks to evade the requirement to reserve capital and thereby push them and their off-balance sheet vehicles to achieve much higher leverage. Second, the securitization of mortgages has encouraged careless lending, such that households borrow more than they are able to pay back. Third, investment portfolio managers’ increased reliance on credit ratings from rating agencies has resulted in a flawed image of reality that depicts prosperous mortgage markets and apparently risk-free investments (Crook, 2008). Credit-rating agencies have admitted that the golden ratings they awarded to many mortgage-linked “structured” products were erroneous, particularly those of collateralized debt obligations (The Economist, 2008).