Subprime Nonsense

The Fed chairman and Treasury secretary say the subprime mess has been contained. Are they joking?

Subprime lending is still a mess

The treasury secretary and chairman of the Federal Reserve play important symbolic roles as knowledgeable guardians of the global financial system. Yet sometimes it’s scary how little they seem to know. Speaking in China last week, Treasury Secretary Henry Paulson reminded journalists that “in today’s world, it’s quite easy to stay close to the markets, and it’s my job to be vigilant and stay close to the markets.” In a June speech, Federal Reserve Chairman Ben Bernanke assured listeners that “we will follow developments in the subprime market closely.”

But these experienced, vigilant market watchers have been incredibly slow to recognize the spread of the poisonous fallout from the subprime meltdown. Testifying on March 28, Bernanke said, “At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.” The same day, Paulson told the House of Representatives that “from the standpoint of the overall economy, my bottom line is we’re watching it closely but it appears to be contained.” In May, Bernanke returned to the containment theme, saying that “we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.” A few weeks later, he reiterated that “the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system.” On July 26, Paulson told Bloomberg, “I don’t think it [the subprime mess] poses any threat to the overall economy.” In China last week, he revised and extended his remarks: “I also said I thought in an economy as diverse and healthy as this that losses may occur in a number of institutions, but that overall this is contained and we have a healthy economy.”

If the containment policy of the Cold War worked as well as this subprime-mess containment policy, we’d all be speaking Russian and living on collective farms. So far, the subprime catastrophe has been “contained” to the growing list of subprime lenders that have failed. And to some pretty big hedge funds in New York, Boston, and Australia that traded the toxic junk produced by the subprime lenders. And to the investment banks that managed some of those hedge funds and lent money to them. And to some nonsubprime lenders, the biggest of which, Countrywide Financial, last month reported declining earnings because of rising defaults. And to smaller nonsubprime lenders like American Home Mortgage, which just five weeks after assuring investors it would stabilize, filed for Chapter 11 this morning. And to the more than 6,000 laid-off American Home Mortgage workers, who, before last week, were utterly insulated from the ravages of the subprime market. And to a German bank. And to the career of Warren Spector, the former heir apparent at Bear Stearns. And to publicly held homebuilders—downscale ones like Beazer, and upscale ones like WCI Communities, the builder of “amenity rich” condos whose board in April dismissed a $22-per-share takeover offer as inadequate. Now the stock trades at about $6.60.

Everywhere you look in the nation’s vast financial FIRE (finance, insurance, and real estate) sector, in fact, it seems the subprime crisis is “contained.” The virus infecting subprime housing debt has now clearly spread to subprime corporate debt. Citigroup and other large investment banks are suddenly finding it difficult to sell the debt they’ve committed to raise for private equity firms so they can buy other companies. Of course, this particular spot of bother is contained merely to the stock of the Blackstone Group, which borrows heavily to finance its deals. And to shareholders of companies waiting for buyouts to be completed, like Sallie Mae and TXU. And to companies that have nothing remotely to do with subprime, or buyouts, such as the department store chain Macy’s, which, like the stock market as a whole, was kept aloft by rumors that a private equity firm might buy it.

In the last couple of weeks, the conventional wisdom surrounding debt—housing and corporate—has changed. For the last several years, lenders and investors have believed that a) debt doesn’t go bad, so it’s OK to commit to huge chunks of debt without asking too many questions; b) lenders can insulate themselves from bad debt, in the unlikely event it should appear, by packaging and selling loans as securities; and c) sharp professional investors who buy and trade these securities, often using debt themselves to increase returns, can protect themselves from losses through the use of newfangled securities called credit derivatives. Events of the last few months have proven that a, b, and c are wrong when it comes to subprime housing debt. That realization, in turn, is leading lenders and investors to wonder whether they’ve also been laboring under false assumptions when it comes to subprime corporate debt. (They have!)

Bernanke and Paulson aren’t entirely wrong in insisting that the subprime mess is contained. The virus, which traces its origins to unhealthy lending practices, is contained—to any entity whose livelihood, business model, or stock value rests primarily on the cheap and easy availability of credit.