Slate's Bizbox
moneybox: Commentary about business and finance.

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

By Daniel Gross
Posted Monday, Aug. 6, 2007, at 6:03 PM ET
Foreclosure. Click image to expand.

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.

Print This ArticlePRINTDiscuss this in The FrayDISCUSSEmail to a FriendE-MAIL
Share on FacebookPost to MySpace!Share with MixxDigg ThisShare with RedditShare with del.icio.usShare with FurlShare with Ma.gnolia.comShare with SphereShare with Stumble Upon
Daniel Gross is the Moneybox columnist for Slate and the business columnist for Newsweek. You can e-mail him at . He is the author of Pop! Why Bubbles Are Great for the Economy.
Photograph of real estate foreclosure sign by Joe Raedle/Getty Images.
Join the Fray: our reader discussion forum
What did you think of this article?
POST A MESSAGE | READ MESSAGES

Remarks from the Fray:

I love it when Wall Street seems to think that putitng make-up on a pig somehow changes the dynamic of the pig itself.

The idea that one can insulate oneself from the ravages of default is technically correct on an individual basis. But from an overall economic basis, the selling of Mortgage Backed Securities is nothing more than a game of Hot Potato. Someone at the end of the day is going to lose out if the original parties to the transactions default.

I am not sure when the dust will settle. As people lose their jobs, they will be less likely to afford their house, which has an increasing monthly payment due to rising interest rates. With a slowing housing market and declining values, many, many more Americans are going to have to foreclose.

This may be the tip of America's next great depression, and with China looming, I am not sure how we will ever get out of it.

--VT Biker

(To reply, click here.)

After complaining bitterly about the bail-out of Bear Stearns, Gross now complains that Bernanke is not doing enough about the sub-prime lending mess. Of course, the only things that Bernanke can do, would, in fact, be a true bail-out.

There is no doubt that the there have been some ripples from the sup-prime fiasco. It is now more difficult to fund LBOs. That may hurt the earnings of Blackstone and KKR and it may hurt the stock market, but that it won't cause the economy to collapse.

Gross states that any business that relies on "cheap and easy availability of credit" will suffer. Why is that bad? Strong business do not need cheap and easy credit. Indeed, most American businesses are flush with cash. So some speculative businesses return to reality and some investors get spanked for being a bit delusional. That is all a normal part of the business cycle.

--SFBurke

(To reply, click here.)

There is no doubt that, during the months he was waiting in the wings to assume the chairmanship of the Fed., Bernanke was paying close attention of everything that Greenspan was saying while the latter finished up his occupancy of that position.

For that reason he was surely aware of Greenspan's oft-mentioned criticism of bond buyers for ignoring risk in their purchase decisions. Now that risk is once again being acknowledged in bond-purchase decisions, ALL sectors of the credit market are being affected, and billions of dollars in market value are being surrendered.

Bernanke, therefore, cannot be speaking honestly when he claims that the current problems can be contained to the subprime mortgage market. Is this the new Fed-speak, in which the chairman will attempt to imitate the style of such luminaries as Rumsfeld, Cheney and Bush?

The Fed has at its disposal the tools necessary to ensure that the credit it creates is used responsibly. Greenspan refused to use them for reasons of personal ideology. Does Bernanke share those prejudices?

--Emigre

(To reply, click here.)

The biggest shame in all this is that we created an economy and mindset in America that is driven by consumption. The artificially lower interest rates of the first half of this decade encouraged lots of discretionary consumer spending, most of which was not affordable. Growth can not be sustained by short term borrowing, only investment can drive an economy. Unfortunately, the Bush Administration's economic strategy was to use interest rate-driven consumer spending to increase corporate profits. This spending has been financed by a combination of debt and sales of assets, both of which are detrimental to the long term economic health of the country. The net effect of the subprime meltdown will be more sensible lending, which will only benefit the economy.

--kgsbca

(To reply, click here.)

While essentially this mess is one in which the fed are complicit, I do not believe that they should "open the discount window!" I believe that would be a mistake and would not necessarily improve the health of our economy. These firms which are taking a bath on the current state of finance, are suffering the consequences of a lack of due diligence. To pretend that we need to save companies such as Bear and Stearns is silly. Why should the government save a company that failed to make smart money moves? This to me is the markets at their best. The companies that failed to embrace the reality that the market cannot continuously expand at an increasing rate will be rewarded, those who got caught up in the herd will be punished, not by the federal government but by market forces.

--Jeremy

(To reply, click here.)

(8/8)

Washington Post
The Washington Post
OPINIONS
Topic A: Obama's Speech
| Pundits and diplomats respond.
Robinson: Sunshine in BerlinToles: Obama the UniterTelnaes: Meanwhile, McCain
PLUS » Stumped: Bring Back Bill Clinton