A Sequel to the Subprime Mess?

There is a vast gap of perception and language between the real economy of production and jobs and the financial economy of loans and investments. The real economy, though weakening, is hardly in a state of collapse. In 2007, it has grown about 2 percent; since last December, payroll jobs are up by 1.3 million. Even among those economists who expect a recession, the dominant view is that it will be mild. Meanwhile, the financial economy is described in dire terms verging on hysteria. Markets are "in turmoil"; there is a "credit crisis."

This contrast reflects—to the extent that it can be explained—fear of the unknown. Since 1980 America's financial system has changed dramatically in ways that are now arousing widespread anxieties. Many loans once made directly by banks are "securitized": packaged into bondlike securities and sold to outside investors (pension funds, mutual funds, investment houses, hedge funds and banks themselves). There's been an explosion of bewildering financial instruments—currency swaps, interest-rate swaps and other "derivatives"—that are used for hedging and speculative trading.

Until recently, the transformation seemed a splendid success. Credit markets had broadened; risk was being spread to a larger spectrum of investors. So it was said. This was an illusion. The securities containing "subprime" mortgages—loans to weaker borrowers—have experienced unexpected defaults and rating downgrades. Some banks and investment houses holding these securities, including Citigroup and Merrill Lynch, have suffered large losses and lower stock prices. More important, the unpleasant surprises have ignited fears among bankers and investment managers over how the new financial system operates.

Credit and financial markets subsist on trust and confidence. The subprime crisis has corroded both. Estimated losses range from $50 billion and up. But because trading in subprime mortgage securities is thin, how can they be accurately valued? Who holds them? Banks and investors have reacted to these uncertainties. For example, banks now find the "interbank market"—banks lending to each other—riskier than before, because they don't know which banks are most exposed. The three-month LIBOR (London Interbank Offered Rate) jumped to more than 2 percentage points above U.S. Treasury bills, triple the historic "spread" of 0.6 percentage points, reports economist John Lonski of Moody's.

The subprime debacle also posed a question: what if it's not the only problem? Consider "credit default swaps" (CDS) as a possible sequel. CDS are, in effect, insurance contracts on loans or bonds: the seller of the CDS receives a payment and, in return, agrees to pay the buyer some or all of the amount of a designated loan or bond if the borrowing company (say, General Motors or IBM) actually defaults. But note, neither party to the CDS has to be the underlying lender or borrower. They can be, and usually are, outsiders. They are simply betting on the creditworthiness of different borrowers.

Since 2004, the volume of CDS has increased about sevenfold. Possible losses could dwarf those on subprime mortgages, argues Ted Seides of Protégé Partners, an investment fund, in the journal Economics & Portfolio Strategy. In a strong economy, defaults on corporate bonds and business loans have been low. On "high yield" bonds (a.k.a. "junk bonds"), they've been about 1 percent recently, compared with a historic average of about 5 percent and 10 percent in recessions. As the economy weakens, junk-bond defaults will increase, Seides says. This will give rise not only to direct loan losses but to additional losses on CDS.