The financial world has been shocked by the sudden crash in the so called “Sub-prime” lending market.  For years major investment funds had freely purchased bonds that paid interest based on the repayment of subprime mortgage loans and now many of those outstanding bonds are in default.  Now the market is trying to predict how the sudden default of millions of dollars of bonds will change future investment decisions.

Now I’m not an investment advisor, and I don’t follow any particular stock or bond, however, I do try to follow the macro-economic world and what I’m seeing and hearing suggests that Wall Street is still in denial about the extent of the damage to come.

The reason we will see extensive damage is rather simple.  The money that has left the economy cannot be magically made to reappear, and companies which have found themselves to be holding worthless bonds are watching sizable amounts of paper wealth vanish.  As this happens the remaining bonds end up with a very questionable value.  Investors cannot be confident that the investments will pay as promised, and are reluctant to invest more until they have a more definite value.  This will force banks to be much more careful in their loans and appraisal values will now have to be much more conservative.  This is going to drive down house prices because banks are no longer going to assume that a buyer who cannot pay the loan will still be able to sell the house at a high enough price to repay the loan.

Banks hate to foreclose.  While it is an option for them, it’s a costly one and ends any payments.  To a company that makes its money based on the interest from loans this is unacceptable.  Especially if the then foreclosed house cannot be resold for the original loan amount.  With housing prices dropping banks are going to have to tighten the requirements they set for loan acceptance, and this is going to make it more difficult for anyone to get a loan at a good interest rate.

Now I know some people are thinking that the Fed can reduce interest rates to help fix the problem.  Now its true that making the interest rate lower will reduce the pressure on banks and allow them to keep the interest rate lower on people who have borrowed money.  However, the current federal reserve bank governors rightly recognize that lowering interest rates could end up doing as much if not more harm than good.  There is a reasonable argument that the boom in subprime lending and in the irresponsible use of mortgage backed bonds to provide the funds to keep the loans going was directly related to Alan Greenspan’s failure to raise interest rates quickly during and after the dotcom bubble burst in 2001. 

The other option we are hearing about is a possible “bailout” where the government puts up money to guarantee the loans currently in default.  This would be a horrible use of government money, and would only generate a great “moral hazard” where those that made irresponsible investment and lending decisions discover that the government will protect them from the consequences of their own actions.  Yes, this does mean that many people who purchased homes might find themselves foreclosed on, or trapped in a home they don’t really want, and cannot sell.  But right now all options leave someone holding a rather empty bag.  There will be economic pain.  The key should to be focus the pain on those that made the bad decisions, either by purchasing a house they could not afford, or those that loaned money to feed the borrowing frenzy.  Those that stayed out of the housing market should not have to pay for the excesses of others.