Analysis: How Bad is the Subprime Mess?

Remember the bank panic of 1907? Probably not. But revisiting it is one way to clarify the differences between the old financial order and the new—and the challenges posed to the new order by the subprime mortgage mess. Higher defaults on these loans to weaker borrowers raise a question: is the new order better than the old? For the U.S. economy, the stakes are huge.

Consider the financial upheaval. Since the early 1800s, banks had dominated the system. People and businesses deposited their cash in banks; then the banks made loans. Now, much money bypasses banks. In 1975, banks and savings and loan associations—close cousins—issued 73 percent of all home mortgages. By 2006, their share of the $10 trillion mortgage market was 29 percent. Almost 60 percent had been "securitized": bundled into bonds and sold to investors (pensions, mutual funds, foreign investors).

The old system had defects. Periodic panics were one. In 1907, rumors of bad loans triggered a bank run. People wanted their money; no one knew which banks were safe. Although the legendary banker J. P. Morgan ultimately organized a rescue of many banks, it was too late. Some banks failed; savers lost funds. A recession worsened.

The panic of 1907 inspired Congress to create the Federal Reserve in 1913. The Fed was supposed to prevent panics by making loans to solvent but threatened banks. The Fed blundered in the Great Depression; two fifths of U.S. banks failed. In 1933, Congress created deposit insurance; that ended traditional bank runs, because depositors knew they'd get their money back.

Still, the economy depended heavily on bank credit. High losses in one area might curtail loans elsewhere, because losses could deplete bank reserves and capital. In the 1980s, banks suffered big losses on commercial real estate and Third World loans. Between 1989 and 1993, 1,418 banks and S&Ls closed. Lending slowed. A recession began in 1990. Recovery was sluggish.

Considering all this, the subprime fiasco might vindicate the new order. Yes, mistakes have occurred—and they're devastating for anyone who loses a home. About 14 percent of mortgages are subprime, and 13 percent of these are at least 30 days overdue. But subprime losses haven't yet depressed overall lending. Arguably, the reason is "risk diversification." Because mortgages are spread among many investors, so are losses. Banks seem financially healthy. For 2006, their profits totaled $146 billion.

"In the overall scheme of things, this is going to be relatively minor," says economist Richard Green of George Washington University. Some mortgage companies that relaxed loan standards (no down payment, flimsy documentation) are going bankrupt. Markets work.

Maybe. But the subprime mess could be the first chapter in a larger horror story. For starters, the housing slump could worsen. More foreclosures put more homes on the market. Tighter lending standards shrink the number of buyers. More supply and less demand further depress home prices. A drop of 20 percent over a decade is possible, Yale economist Robert Shiller tells Barron's. Shaken homeowners feel poorer and spend less.

Subprime losses also might foreshadow losses on other new securities. Some of these bundle other loans: auto loans, credit-card loans, business loans. In 2006, issuance of all these "asset-backed securities" totaled $748 billion, says Moody's Investors Service. Other securities perform more exotic tasks. "Credit default swaps" in effect provide insurance against losses on loans (one party pays the other to cover specific losses if they occur).

In theory, all this diversifies risk; in practice, it may disguise risk.

Companies that approve loans ("originators") often don't hold them. Loan standards may slip because originators get paid on volume. "The originator has less reason to worry about loan performance down the line," says economist Joseph Mason of Drexel University. Rating agencies such as Moody's and Standard & Poor's evaluate creditworthiness. But the task is gargantuan and global in scale. Moody's rates 100 nations, 12,000 corporations, 29,000 governmental units and more than 96,000 debt securities. Economist Charles Calomiris of Columbia University worries that agencies may subtly relax ratings because the more securities that are issued, the more the rating agencies make.

The verdict on the new order is unsettled. No one really understands its Byzantine ways. "It has become so complex and so arcane," former Fed chairman Alan Greenspan said recently, that it is "swamping" governments' regulatory controls. Yet, it "seemingly works because there is an implicit, invisible hand which creates ... smoothness." Most markets, he said, self-regulate. That's reassuring—up to a point.

Greed and fear are not always self-correcting. If foreign and domestic investors lose confidence, who knows what might happen? Credit might become scarcer as they retreat to safe securities. Interest rates might rise. A panic is conceivable. The biggest upsets "come out of left field," Greenspan noted. "We never anticipate."