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2 Subprime and the biggest risk
of all By Max Fraad
Wolff
products have been
inexpensive and the hunt for yield intense. There
is more capital chasing riskier assets to gain
acceptable returns. Lower-quality loans are made,
hedged, bundled and sold. The serious systemic
risk associated with the recent subprime episode
stems from the prospect that the new financial
architecture is less robust and more highly
correlated than assumed. The rising cost of
hedging debt positions and greater
fear of lending to riskier borrowers is far more
worrisome to us than the US subprime market.
New risk product and the rapid growth of
established hedging and sharing contracts and
trading techniques have boomed. From a systemic
perspective, this does not reduce total default or
shock exposure. Redistribution and repricing of
risk occur. This is valuable and acts as a shock
absorber for intermediaries that would otherwise
have to restrict activity or ride unsound direct
loss exposure. As higher risk assets are sold or
hedged, there has been a tendency to use the
raised cash to purchase other risky assets in the
hunt for yield.
A prime example comes
from the CDO (collateralized
debt obligation)/mortgage-securitization process.
As banks issue mortgages they assume a first
loss position (FLP) to be able to sell off the
loans for securitization. If we assume a fully
funded standard contract, the banks pass the loans to
a special purpose entity/vehicle (SPV) that
sells the loans and assumes the loss position.
Losses from "unlikely" system shocks are partially
passed to the buyers of the securitized loan bundle,
but that first loss position means the banks
still bear risk. In addition, the total reduction
in risk achieved hangs heavily on what is done
with bank proceeds generated by this process. You
guessed it, the evidence is that banks make
further loans and repeat the process. The good
news is that banks have a more diversified,
riskier portfolio. The bad news is that risk
exposure does not fall, it rises. The total risk
in the system rises and is diversified and more
broadly shared. This is the good news and the bad,
out of our brave new era.
We see subprime
as risk and valuable lesson. This market is in for
a rough run. There are sweet dreams of
containment; they defy reality. There is no such
thing as a subprime neighborhood. Subprime is
concentrated more heavily in some areas than
others; it is everywhere. Thus broader
housing-weakness questions are when and how bad,
not if. Hundreds of billions of dollars in loans
were made to people who clearly could not repay,
absent significant annual house-price appreciation
and cash-out refinancing. This means that we made
housing loans to create housing-price appreciation
on which loan repayment was predicated. Sometimes
we are tempted to think that this credit boom has
gotten a bit out of control. There is no long-run
safe substitute for earnings, savings and income
growth when increasing credit. This is not to say
there cannot be a lot of money made, valuable
financial innovation and long periods of great
returns.
The other vital lesson involves
our brave world of fully managed risk and nearly
perfectly hedged positions. Have other markets and
asset classes become dependent on credit growth to
drive up asset prices to allow further credit
growth? A huge Maginot Line of default defense has
been erected to keep loss exposure out. Many
valuable and potent new risk-management techniques
and products have been developed. Riskier
borrowers remain risky to all the various parties
that extend credit to them. This showed up fast
and furious as the cost of credit-default
protection shot up and interest-rate premiums
snapped into correlated action with every increase
in subprime stress.
The greatest risk may
be in thinking that risk has been conquered. It
cannot be. It has not been. Risk has simply been
redistributed and repriced, downward. As perceived
risk fell and sharing grew, new monies were freed
up for riskier lending and new, riskier projects.
Loans went through and new projects were launched.
Default risk continued/continues to grow as credit
grows and allocations hunt for return. There is no
innovating around this basic reality of financial
gravity.
We are looking for periods of
contagious fear in credit-risk-reduction markets
feeding back and forth with particularly risky
asset markets. The real danger slumbers - we hope
- so long as massive quantities of cheap credit
allow the roll-over financing of future rounds of
debt. If this slows sharply, or runs in reverse,
US subprime housing turmoil is the tip of the
iceberg. There has been a lot of subprime
allocation of capital and risk across the past few
years. Subprime will either become a heeded
warning shot across the bow, or a prelude to
violent repricings to come.
Max
Fraad Wolff is a doctoral candidate in
economics at the University of Massachusetts,
Amherst, and editor of the website
GlobalMacroScope.
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