March Madness Goes (Sub)Primetime

March madness is in full swing. It's not the Cinderella's that are causing all the commotion however, it's sub-prime lending that's been the sleeper in there opening rounds. Sub-prime loans are financial obligations extended by lenders to borrowers with sub-prime credit worthiness. You can think of them as the 16 seeds of the credit markets. While you might bet some funny money on them, you're not going to blow you whole wad on Jackson State (Go tigers!). They are priced higher, carry steeper interest rates, and often times have an adjustable rate linked to them that can ratchet up over time and generate larger monthly payments. While these products can be a great tool to employ if you are a borrower that has less than ideal credit and understands their risk, they can also be a risky invitation to gamble with your financial stability in the future (especially during periods of rising interest rates). This posting isn't a warning cry to the consumer, to them: caveat emptor (buyer beware). What this posting is, however, is a warning cry to capitalism. The free market we all embrace is in serious jeopardy and the shot clocks' winding down.....

Let's take a magical journey along the path of a sub-prime loan. A borrower (the Smith's) walks into the office of a mortgage broker and requests funds for the purchase of a home. The American dream is financed by using an adjustable rate mortgage (ARM) that has an initial 'teaser' rate that will adjust (rise in the present environment) at a set date in the future. The Smith's are happy and the new home is theirs. The bank (continually looking to hedge their risks and exposure) bundles the Smith's loan with other loans in their portfolio and sells them on the open market. These derivatives come in a variety of shapes and sizes, but all of them are some sort of tranche or strip that carries an expected (guesstimated) return that is tied to the underlying 'packaged' loans. Investors buy these tranches to take advantage of the higher yield and cash flows that are created as the borrowers (the Smith's) pay back the interest with their monthly payments. Now, as we all know there can be no increased return without the acceptance of added risk right?. In lies our problem.....

Our current fixed income environment is such that yields are low and investors are salivating at the opportunity to get increased yield out of their investments. This demand is causing lenders to continue to write more and more of these sub-prime loans. As long as the banks know they can unload these obligations onto investors they will continue to make them. This shifts the risk onto the investor (institutional and individual alike) and away from the banks that are underwriting.....

So, what does all this mean and why has it been such a catalyst for volatility this last week plus? Well, here's why. No one understands or can quantify what the true impact would be to the credit markets and banking system if these defaults (the Smiths stop making their house payments) started to occur. Could it be the small pebble that starts the tsunami? Probably not. But could this situation be an opportunity for the federal government to play hero and bail out this market to avoid any sort of fallout. Yes! And what better move politically than to help out the poor ole Smith's who are having trouble paying their mortgage. It would be a great move for an administration that is tainted at best in the eyes of the blue collar crowd they tend not to notice. It sounds like a great plan right. Absolutely not!

A capital intervention into the markets of this country can be justified in remote circumstances (I'll let history provide the examples). We have to maintain stability and guarantee to a certain degree in our economies markets. This simple reassurance of stability is what separates developed economies from developing ones. We rely on access to credit and we have faith that our banking system will support it by remaining solvent. However, we don't require all investments to work out all the time. If pricing is such that it doesn't reflect the risk, we have to be willing to allow arbitragers to bring the sides together. If through this correction there is some fallout and loss we must bear it. What we can't do is intervene to a degree where people's behavior will rely on this type of life boat in the future. The difference between a charge and a block is a judgement call that can be decided by less than a step at times. Let's do the right thing in this game and leave it a no call......