There is only one problem with Gretchen Morgenson's excellent article in Sunday's New York Times exploring whether troubles in the subprime lending industry will spread further into the opaque territory of high finance. No hyperlink is provided for the equally excellent paper by Joseph R. Mason and Joshua Rosner that marshals the most complete set of reasons I've yet seen for why we should be increasingly worried: "How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions?"
Morgenson is one of the best business reporters currently working, and when she cites a paper it is usually worth following up on. (Another example was her discussion of energy trade speculation, which alerted me to the enlightening government report "The Role of Market Speculation in Rising Oil and Gas Prices: A Need to Put the Cop Back on the Beat.")
The report examines in detail structural changes in the mortgage lending industry over the past couple of decades, along with the evolution of the ever more complex financial schemes devised by Wall Street to create high-yield investment opportunities for those investors who wish to buy and sell the risk that borrowers may default on their loans. The conclusion is that the subprime woes are likely to cause further problems downstream. The recommendation is for increased "transparency" in how these financial instruments operate and how risk and value are calculated, both at the bottom-rung level of individual loans to home-buyers, and at the top-rung levels that include such exotic fare as "collateralized debt obligations," which pool together groups of mortgage-backed securities and allow investors to pick and choose exactly what slice of risk they want to expose themselves to.
Some excerpts from the executive summary, and a closing section on policy implications:
Structural changes in the residential mortgage lending industry including reductions in down-payment requirements, relaxed underwriting standards, the movement to automated valuation and underwriting systems largely went unnoticed by mortgage-backed securities investors until only recently. This report explains that those changes went unnoticed largely because of the existing complexity and valuation difficulties underlying today's mortgage-backed securities markets...
...High yields in mortgage-backed securities in the past several years led to a massive infusion of collateralized debt obligation "hot money" into the mortgage-backed security sector in an environment similar to that of the thrift crisis of the late 1980s. Like the thrift crisis and its aftermath, therefore, recent events not only threaten these institutions, but also threaten the U.S. consumer and taxpayer as well.
The key economic indicator to watch as 2007 continues? How far and how fast home prices continue to fall. Declining home prices are good for aspiring homeowners who have been kept out of the market by sky-high costs, but they could be very, very bad for investors who are depending on loan repayments from homeowners who can't pay their mortgage obligations and can't get out of them because their homes are now worth less than their loans. And if those investors continue to get hurt, that in turn will tighten credit access for everyone.
Readers who have been following my attempts to understand what the housing bust portends for the U.S. economy know that it is something of an obsession here. The Mason-Rosner report is the best, most up-to-date explanation of what's going on that I've read so far.
UPDATE: I don't usually link to letters signed anonymously, but this one blasts the report referenced above so vociferously that I thought it worth highlighting.