March 18, 2007

WSJ Op-Ed on Mortgage Market Misses One Important Point

Filed under: Business Moves,Economy,Taxes & Government — Tom @ 3:04 pm

In Monday’s WSJ, Alex J. Pollock of the American Enterprise Institute wisely counseled (requires subscription) against a government overreaction to the mortgage-industry muddle, but missed one striking difference between this mess and previous ones:

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.

Pollock is of course correct that over-regulation won’t work, but what he misses is how distorted the markets of the past few years became because of the deliberately lax credit standards of Government Sponsored Enterprises (GSEs) Fannie and Freddie Mac (which many others in the private sector felt they had to imitate if they were to compete).

I don’t think anyone knows how much gunk and junk are on the books of either of these GSEs, both of which are described here as “recovering from accounting scandals” (note: not “recovered” in the past tense). I’m afraid that when we find out, the idea that Uncle Sam will just blithely (and, in my opinion, incorrectly) step in and make up the difference will be put to a severe test. If it gets that far, there will be tremendous lobbying and hysteria by the holders of mortgage-backed securities to claim that this is what the government “promised.” Governments don’t have a good track record of standing up to such pressure.

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UPDATE, March 19: Liz Moyer at Forbes says not to worry:

But from a bond market analyst’s perspective, fears of a broader contagion are overblown. Just 1% of the mortgage bonds securitized so far this year and rated by Moody’s Investor Service have been downgraded or put on watch, for example. That’s out of $149 billion securitized since January.

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