The second subprime crisis and other observations

Far from being an expert on mortgages or fixed-income markets, as most people, it's not easy fully understanding what's going on. So the only thing I can offer is to share what I'm learning.

First of all, if you really want to understand these mortgages, go read this IMF study, a true eye opener. For starters, it turns out that this is the second subprime crisis. In 1998-1999 most subprime lenders went bankrupt after the Russia/LTCM crisis. The difference between this crisis and today's situation is that the total amount of subprime mortgages was much, much smaller, which is why it didn't receive much notice.

A few additional points:

1. It's rather silly blaming securitization per se for the subprime mortgage meltdown. All sorts of loans have been securitized into bonds, including risky ones such as credit card debt. So why did the supply chain break so badly in this case? It probably has to do with the bubble mentality that set in over the last few years and a lack of a coherent regulatory framework. That said, I do wonder what will happen when the loan originators/services, who supposedly manage these mortgages, go bankrupt. Who collects? This can be very tricky.

2. The real problem, as this BIS report shrewdly noted in 2006, is that subprime mortgages are a fairly recent product (mid-1980's) that came into being during a period of high economic growth, only two mild recessions, rising house prices and declining interest rates. Hence, the models for valuing likely can't handle/didn't take into account high stress scenarios, such as falling home prices, leading to over-optimistic pricing and, thus, losses when they materialize.

3. As I noted yesterday, given the lack of credible valuation models and ratings for these bonds, somebody has to step in. It could be financial firms, although they disturbingly show no inclination to do so even when their own funds and reputations are on the line. Enter the lender of last resort, aka the Federal Reserve.

4. Call me Cassandra, but I will say it once again: the current mess in the markets is serious, but its danger pales besides the one posed by the nexus between increasing foreclosures and falling house prices. I second Paul Krugman in calling for the Fed and other regulators to step in and coordinate borrowers and lenders (via Economist's View).