Subprime Mortgage Crisis vs. the S&L Meltdown

I remember the dark days of the S&L crisis well; in fact, before becoming a real estate market analyst my first job out of college was working for the long-defunct Imperial Savings & Loan in the Treasury Department. I was put in charge of ensuring that the value of the company's $1.3 billion in mortgage-backed bonds, other CDOs (including car loans) and commercial paper would remain high enough to avoid defaulting on various collateralized loan covenants (including the lease on the company's HQ in San Diego). "Marking to market" (i.e., obtaining the current value of the securities) was a mess even back in those days, especially since we were coming up on the market bust of 1987. It was really due to the opacity of the securities industry that I decided to enter the "tangible" world of real estate -- just in time for the boom and bust cycle of the late 1980s and early 1990s!

Today's Wall Street Journal has an excellent story comparing the current mortgage & liquidity crisis with the infamous S&L meltdown of the late 1980s as well as the stock bust of 2000-2002. With separate interviews with George Soros, Paul Volcker (Fed Chair before Greenspan), William Seidman (former FDIC chief) and Robert Shiller (Yale professor and co-architect of the Case-Shiller index), the sheer complexity of financial instruments backed by mortgages makes it difficult to predict the eventual outcome, although so far it hasn't risen to the level of losses experienced during the stock bust of 2000-2002 (see table above).

In some ways, the S&L bailout was simpler because the players were known, but this case is much different. While the shifting of risks from banks to securities markets has helped fuel global growth of mortgages and other types of lending, it's not yet been tested for what former Fed Chair Volcker calls a "major-league crisis." Explains the article:

Mortgages today are dispersed among banks as well as more than 11,000 investment pools, each of which may have hundreds, if not thousands, of investors. Many of those pools have been further repackaged into specialized funds known as structured investment vehicles and collateralized debt obligations, or SIVs and CDOs -- each of which have their own investors. That makes determining who owns the securities, what they are worth and the nature of the underlying collateral a tricky process.

David Barse of Third Avenue Management LLC, a New York investment firm specializing in distressed companies, is steering clear of CDOs for now. He says he would need to hire new experts just to figure how much they are worth. "We don't have the analytical systems to break them down," he says.

Indeed, coming up with a value for a CDO entails analyzing more than 100 separate securities, each of which contains several thousand individual loans -- a feat that, if done on any scale, can require millions of dollars in computing power alone.

This is also why the three band-aid approaches provided by the government -- including (a) the two recent rate cuts and the one expected tomorrow, (b) the now-apparently imperiled "super fund" created by banks to create a ready market for mortgage-backed securities, and (c) freezing interest rates on *some* subprime loans (can you say "political?") -- may not be of much use in the short term.

Many analysts think that the U.S. government intervening in private markets sets a bad precedent and may constrict future mortgage liquidity, although columnist Lou Barnes makes a case for protecting unsophisticated borrowers from modern-day loans sharks.

I'd expect this entire situation -- and its solutions -- to slowly play out throughout 2008 and into the first part of 2009.