Stop Calling it the Subprime Crisis!

I think it is pretty safe to say that we can stop calling it the subprime mortgage crisis. I went to an event at the Hudson Institute this week with this title. Robert Edelstein from UC Berkeley had a good presentation which provided an informative review of the issues but the dramatic events of this week were making understanding the crumbling system more of an historic exercise. Many of the actors in the play were already being played by understudies and the script was being rewritten on the fly.

Sure, the earliest indicators of pervasive financial distress began when the performance of subprime loans started to sour last year. But I think it is safe to say now that the financial turmoil which is unfolding in real time extends well beyond the subprime mortgage market. It never really made sense to begin with anyway since the fall of home prices from their precipitous heights was hardly unexpected, especially in the areas where the run-up had been so steep. Increasing default rates should have been predicted as a nature course of events when the housing bubble eventually popped. This sound has been heard of before. It is a dynamic that has been studied and observed. Yes, gravity is just a theory but we still know that the apple will eventually fall.

However, I have no problem with calling what we are experiencing a mess. I just think it is a bit unfair to lay the blame at the feet of subprime borrows. Even the unscrupulous purveyors of subprime products should not be entirely blamed. In theory, risk-based pricing has the ability to get people into good loans and good homes than they otherwise would be able to do, but all too often it lead to getting people into good homes and bad loans, that they either did not need to be in or could not afford to stay in. Certianly many subprime lenders had a business model that was offensive. And yet regulations were lack, the risks they faced were low, few people were paying attention, and they were told there was nothing wrong with the profit motive.

Unfortunately, despite our need to find resolution in assigning blame, I believe there have been too many culprits at work. Clearly a role was played by the lenders, the banks, the formerly Government Sponsored Enterprises of Fannie and Freddie, the accountants, the insurers, and just about all of the major players in the global financial system. Perhaps we will look back in hindsight and marvel that our national system for financing homeownership became one of the foundations for conducting global finance. The drive to create financial products such as mortgage-backed securities that could be sliced, diced, and sold got away too far ahead of the ability to estimate and understand their underlying value, risk, and ultimately price.

As we watch the financial unraveling, the complexity of the arrangements is maddening. Steven Pearlstein makes a useful attempt to explain the current state of things in today's Washington Post. He calls it a category 4 financial storm. It seems to me, though, that most of the experts are just as confounded as those of us reading the new stories. What I do know is that the roots of the problems were structural. They emanated from the policy choices we made to govern financial markets. These choices should be revisited structurally as questions of governance and government (our U.S. federal government) will have to establish the new rules for the market which provide protection and security for consumers, small investors, and big investors alike. The era of small government and deregulation is over.