When How the World Works first began checking in on the state of the U.S. housing market, the rationale for including such a topic in a blog ostensibly about globalization was straightforward:
American consumers are the locomotive pulling the global economy forward. The rapid appreciation of home prices in the great housing boom of the early 21st century gave those consumers access to a seemingly unlimited ATM of home equity financing. If the housing bust turned off that spigot, then the global economy might go off the tracks.
A year ago, HTWW had little clue that the subprime mortgage lending market would be the first great casualty of a popped housing bubble (although as far back as last April, I did note that some Wall Street hedge funds had begun to bet on a bust). But a separate fixation of this space has always been the exotic world of derivatives trading, and it has been enlightening to watch how the housing bust has become a narrative about derivatives. The repackaging of subprime mortgage bonds into "collateralized debt obligations" -- a derivative instrument that has boomed in popularity over the past decade -- is the stuff of daily coverage in the financial pages today, with no one particularly sure whether what we are seeing is the Achilles' heel of the global economy finally exposed or proof that modern financial systems are sophisticated and resilient enough to survive any shock.
Whatever the case is, the narrative provides another angle on globalization. As the Wall Street Journal reports today, European investors are discovering that they unwittingly exposed themselves to the U.S. housing bust by buying collateralized debt obligations that included repackaged American subprime mortgage loans.
Investors are realizing they may own more exposure to subprime-mortgage-loan pools than they thought.
That exposure is surfacing because of the way fixed-income investments can be layered. Banks sell asset-backed securities, known as ABS, backed by mortgages to investors. The ABS can ultimately end up in complex structures called collateralized debt obligations, or CDOs. Institutional investors invest in CDOs, sometimes not realizing they have subprime mortgages in them.
"There are European investors who until a few weeks ago did not know an awful lot about what subprime was who are realizing that they actually have exposure through some of their CDOs," said Citigroup credit strategist Hans Lorenzen. "I've spoken to one investor who said that their portfolio had exposure to subprime and they just knew that it had some American ABS exposure. They hadn't gone through enough detail" of their investment to realize they owned loans to Americans with spotty credit records.
Because derivatives trading is relatively unregulated and exceedingly complex, no one really knows how exposed European investors (or big American players like Goldman Sachs or Citigroup) are to the subprime mess. It's also true, as the New York Times reports today, that if you were smart enough to bet on a housing bust coming true, you are making good money now off of subprime misfortune. Maybe risk has been sufficiently spread around and hedged in so many different directions that for every loser there will be a winner and it will all balance out in the end. That would be nice, for the global economy.
But the deeper story is that the evolution of derivatives trading, in which ever-more-complex securities that are created by repackaging underlying assets (home loans, car loans, stocks and bonds and futures options and so on) in ever more innovative ways, is resulting in a global economy where investors all over the world, whether they know it or not, have a finger sticking in everyone else's pie. So the risk for a home loan made to a Californian with bad credit may end up partially borne by a hedge fund in Latvia. And a meltdown anywhere ripples into everywhere.