Friday’s Wallstreet Journal front-page headline reads “Subprime Bonds Are Back.” The article explains that prices in the subprime bond market have recently doubled from 30 cents on the dollar, which was the lowest point during the crisis, back to 60 cents on the dollar. And not only that, non-agency bonds, i.e. bonds that are not backed by Fannie Mae or Freddie Mac, are also experiencing higher yields. Oh and WSJ is happy to suggest that ordinary borrowers are benefiting from this renewed interest in the subprime market because banks are now willing to lend again; they even give out jumbo loans for as little as 5.5% for 30-year loans. The article further reports that several regulatory changes “that have taken place over the past two years are encouraging traditional investors to take a second look at the [extremely risky] assets.” Specifically, state insurance regulators have reduced the requirements for how much capital insurers have to hold against residential mortgage securities, if the securities are bought at a discount.
My head is spinning as I am reading this. This blatantly obvious return to pre-crisis risk taking seems insane, especially when it is reported as if it were ‘good news.’ Isn’t one of the potential explanations for the crisis related to excessively leveraged households and banks? How did state regulators decide that responding to excess leverage by reducing capital requirements for investments in mortgage securities, which effectively makes it possible to take on even more leverage, was the right thing to do?
Now you might say, well maybe the housing market is recovering and this is just the return to normal. Homeowners that are still around, even if they are part of the subprime market, will eventually repay 100 cents on the dollar they borrowed. Another argument that might make this new trend seem more reasonable is that the probability that homeowners will not default on their mortgages is probably greater, if they made it through the last crisis. However, the economist reports this weekend that the U.S. housing market is still in recession, in fact “the S&P/Case-Shiller home-price index for 20 cities fell by 3.1% in the three months to January from the same period in 2010,” that sounds to me like foreclosures aren’t over yet.
Don’t get me wrong, my private learning curve is not very steep either, but it is still sloped positively. This looks to me like a negative learning curve for financial markets. Ridiculous regulation (like those lower capital requirements that the WSJ reports) has destroyed knowledge and reason has completely gone out the window. I guess I should not be surprised. We know (from Mises, Hayek, & Kirzner) that learning in a market context requires both profit and loss. You only know that you have discovered, developed, or produced something valuable, if you can sell it profitably to other people. Similarly, you know that you are doing something wrong with your scarce resources, if you are making a loss. This means that losses are just as important as profits for a market to function correctly and to create useful things. When either of the two signals is distorted, markets don’t do us any good; in fact, they can destroy value. This is what happened in the Soviet Union and it seems to be happening in financial markets currently.
When the federal government intervened to soften the crisis, the treasury and the Fed bought insolvent banks, which should have realized losses. Those banks and financial institutions would have foreclosed without the intervention, instead they were rescued and continued to operate. That means they did not learn anything about excessive leverage and risk taking. They did learn one thing, however; they learned that no matter how much risk they take or how much money they lose, their executives will go home with a lot of money at the end of the night. Looked at from this perspective, it makes sense that they would go right back to making the same mistakes again. Almost no one in the banking industry had to suffer any losses, because fiscal + monetary policy disabled the profit and loss system, so no one learned a lesson. Are you ready for the next financial crisis? Looks like it is just around the corner!
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