Page 2 of
3 Why the subprime bust
will spread By Henry C K Liu
$3.3 trillion repo (repurchase
agreement) market, and a global derivatives market
with notional values surpassing an unfathomable
$220 trillion. Granted, notional values are not
true risk exposures. But a swing of 1% in interest
rate on a notional value of $220 trillion is $2.2
trillion, about 20% of US gross domestic product.
This practice of borrowing short-term at
low interest rates to lend long-term at higher
interest rates, known as "carry trade" in bank
parlance, when globalized by
deregulated cross-border flow of funds eventually
led to the Asian financial crisis of 1997, when
interest-rate and exchange-rate volatility became
the new paradigm. Today, there are undeniable
signs that the same interest-rate risks have
infested the US housing bubble in recent years.
And the Fed's traditional gradualism, now revived
as "measured pace" in raising the Fed Funds Rate
targets in response to rapid asset-price
inflation, has had little effect in curbing bank
lending to fund rampant speculation.
In
2005, Greenspan repeatedly denied the existence of
a national housing bubble by drawing on the
conventional wisdom that the US housing market was
highly disaggregated by location, which was true
enough. Disaggregated markets are normally not
exposed to contagion, a term given to the process
of distressed deals dragging down healthy deals in
the same market as speculator throw good money
after bad to try to stem the tide of losses. But
the bubble in the housing market was caused by
creative housing finance made possible by the
emergence of a deregulated global credit market
through finance liberalization. The low cost of
mortgages lifted all US house prices beyond levels
sustainable by household income in otherwise
disaggregated markets.
Under cross-border
finance liberalization, negative wealth effects
from asset-value correction are highly contagious.
For example, the Dallas Fed Beige Book released on
July 27, 2005, states: "Contacts say real-estate
investment is extremely high in part because the
district's competitively priced markets are
attracting investment capital from more expensive
coastal markets." The nationwide proliferation of
no-income-verification, interest-only, zero-equity
and cash-out loans, while making financial sense
in a rising market, is fatally toxic in a falling
market, which will hit a speculative boom as
surely as the sun will set. Since the money
financing this housing bubble is sourced globally,
a bursting of the US housing bubble will have dire
consequences globally.
Through
mortgage-backed securitization, banks now are mere
loan intermediaries that assume no long-term risk
on the risky loans they make, which are sold as
securitized debt of unbundled levels of risk to
institutional investors with varying risk appetite
commensurate with their varying need for higher
returns. But who are institutional investors? They
are mostly pension funds that manage the money the
US working public depends on for retirement. In
other words, the aggregate retirement assets of
the working public are exposed to the risk of the
same working public defaulting on their house
mortgages.
When a homeowner loses his or
her home through default of its mortgage, the
homeowner will also lose his or her retirement
nest egg invested in the securitized mortgage
pool, while the banks stay technically solvent.
That is the hidden network of linked financial
landmines in a housing bubble financed by
mortgage-backed securitization to which no one
until recently has been
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