In the wake of Tuesday's market turmoil, which most analysts are attributing to the accelerating stream of bad news from mortgage lenders, it might be educational to recall some of the early explanations of why trouble for some subprime lenders was unlikely to spread more widely.
The big Wall Street investment banks that were giving the mortgage lenders the lines of credit with which to operate, and then turning around and buying the mortgage-backed securities that repackaged the risk of default inherent in those loans, were safe from harm, we were told, because they had protected themselves with "buy back" or "repurchase" clauses in their contracts with the lenders.
Typically, the repurchase agreement stipulated that if homeowners defaulted on their mortgages too quickly, the lenders would have to buy back the loans that they had sold off. So those subprime lenders that were unloading their loans almost immediately after making them weren't really selling off the risk embedded in those loans. If the loans were bad, they'd still be forced to eat them.
The prevalence of buy-back clauses befuddled me when I learned about them, because I didn't quite understand the point of handing off your risk of default to someone else, if you were still on the hook if anything went wrong. I was even more confused when informed that similar provisions applied widely in the entire hotly expanding universe of credit derivatives. As I've struggled to understand credit derivatives over the last few years, I've been told again and again that they make the overall financial system more resilient than ever before, because all this buying and selling of risk insurance has spread risk around so widely that the system can handle any shock. But if the sellers of protection can renege on their promises if something really goes awry, then what, actually, is being protected?
As it turns out, it's not quite so easy for Wall Street to shrug off the excesses of the subprime lenders. As the Wall Street Journal pointed out on Tuesday, enforcing repurchase agreements can be challenging when the original party doesn't have any funds to make good on its obligations. Credit Suisse and Goldman Sachs and Morgan Stanley can send subprime-debacle poster-child New Century Financial Corp. all the default notices they want, but you can't get blood from a bankrupt stone.
The question of the day continues to be whether the subprime mess will spread its tentacles into the larger economy. Preliminary indications in the affirmative are thought to be what spooked investors on Tuesday, but I don't think that anyone yet has a solid handle on what is going to happen. But one of the first lessons of the housing bust should be clear: Someone eventually has to pay the piper when a market goes sour, no matter how much protection is bought and sold. Wall Street's biggest financial players were fundamental enablers of the subprime lending spree; to think that they can escape the "carnage" with just some minor flesh wounds seems unlikely.
UPDATE: MarketWatch has an alarming story on further deterioration in the mortgage lending industry, which might explain why, as of 9:35 a.m. Pacific, the Dow was down about 90 points.