Credit Crack-Up
By Alex J. Pollock

The sub-prime mortgage lending boom has now turned fully to bust. Mortgage delinquencies and defaults in the $1.3 trillion sub- prime market have shot up to unexpectedly high levels, with surprising speed. Numerous sub-prime lenders have failed or closed. Delinquent home-equity loans are rumored to be attracting secondary market bids of 15 cents to 25 cents on the dollar. HSBC, a world class bank, has announced embarrassing losses in sub-prime credit, and made corresponding management changes.
Stock prices of major sub-prime specialists have collapsed: a fall of about 94% for New Century Financial, 65% for Fremont General and 85% for NovaStar Financial from their respective 52-week highs to the March 9 closing prices. New Century is the subject of bankruptcy speculation; the FDIC has put a severe regulatory clamp-down on all Fremont's operations; NovaStar has announced that it expects little or no taxable income over the next five years.
This all raises a fundamental question about risk: If private investors want to take credit risk, and borrowers want to take a chance in order to own a house, should they be allowed to, even if it might lead to consequences like the ones mentioned above? I'd say they should. Credit is a central force in a market economy, and boom-and-bust cycles are the unavoidable price of achieving the long-term growth that markets -- and nothing else -- create. Without the freedom to make mistakes, there will be no growth.
Markets also have their own corrective responses. The various segments of the sub-prime market have already raised credit standards on their own (however belatedly). Credit has tightened for consumers with lower credit ratings, as has financing for the sub-prime lenders themselves, and for securitizations -- reducing liquidity for all of them. On top of this, banking regulators have recently issued additional, tighter credit "guidance" -- too late to avoid the problems, but probably in time to help pro-cyclically push the market further down.
Of course, some might reasonably wonder if the market is self- correcting enough. How could all these problems arise, you might ask, given our massive computer power manipulating mortgage data with sophisticated models built by mathematical experts? The former CEO of Household International, which became the sub-prime arm of HSBC, reportedly bragged that his operation had 150 Ph.D.s to model credit risk. Shouldn't this make us a little nervous about the large sub-prime securitization market -- with securities tranched and sold to yield-hungry investors based on the models of the credit-rating agencies?
Focusing too much on these questions, however, somewhat misses the point. Rather than obsessing over statistical measures of risk, much more important are the human elements of risk; these include short memories and the inclination to convince ourselves that we are experiencing "innovation" and "creativity," when what is really happening is a lowering of credit standards and increasing leverage.
Human elements of risk also include optimism, gullibility, longing to make easy profits, short-term focus, genuine belief in the extrapolation of so-far successful speculation, group psychology or the lemming effect, and in some cases, fraud.
None of this is new. Today's sub-prime mortgage bust displays the classic patterns of credit over-expansions as they have recurred every decade or so for centuries. Such credit celebrations are based on optimism and a euphoric belief in the ever-rising price of some asset class, which in this most recent case includes houses and condominiums. They typically entail the belief that the economy has changed in some fundamental way, and that a "new era" is beginning. The euphoria is inevitably followed, just as now, by a bad hangover of defaults, failures and losses suffered by both the average Joe as well as financial professionals.
The great British financial journalist Walter Bagehot observed back in 1873: "The mercantile community will have been unusually fortunate if during the period of rising prices it has not made great mistakes. Such a period naturally excites the sanguine and the ardent; they fancy the prosperity they see will last always."
Nothing fundamental has changed about this in 134 years: the huge amount of financial legislation in the meantime notwithstanding. In the recent period of rapidly rising house prices, which seemed like it would continue indefinitely, the sub-prime mortgage community, sanguine, ardent, and enjoying success, made some significant mistakes, and further excessive speculations will doubtless come to light. The current bust will also reveal its own swindles and scandals, as have its many predecessors.
Wall Street analysts and traders are now scrambling to figure out who holds these risky assets. At the same time, as in the past, the specter of political overreaction looms large. Will Congress address this problem with a "Sarbanes-Oxley Act of Mortgage Finance" or some similar punishing of the innocent along with the guilty? That is one road better not taken.
Mr. Pollock, a resident fellow at the American Enterprise Institute, was president and chief executive officer of the Federal Home Loan Bank of Chicago from 1991 to 2004.
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