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Mortgages & Refinancing

She Called the Mortgage Mess

T. Rowe Price's "duchess of doom" sees more trouble ahead in the bond market.

Analyst Susan Troll spotted problems in the subprime credit market early.

What tipped you off to the problems in the subprime market?
There were a lot of red flags. Underwriters dramatically lowered standards while lenders struggled to maintain loan volume and market share. The bonds backing those loans were clearly deteriorating in credit quality, but every deal that came to market was priced at a richer level. There was tremendous growth in the subprime credit markets, but the markets were still relatively new. So, many participants relied on models using historical data. But the securities had never been tested during stressed economic environments. It made me feel as if the whole thing was a house of cards.

Have we overreacted?
I don't believe so. The subprime market was so irrational that a huge correction was absolutely necessary. But what surprised me was the speed and severity of the downturn. The collapse has spread through the entire asset-backed bond market -- good bonds and bad. The market remains very dislocated.

What happens next?
We're only about halfway through this mess. There will be further write-downs and further declines for these securities. A large number of loans will reset this year. At the same time, a number of refinancing options have disappeared. Until home prices bottom out, maybe another 10% to 15% from here, it's hard to value these securities. And subprime lending as we know it is history. That market won't come back. Lenders will go back to good old lending standards -- 20% down payments, documentation of income.

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Sidestepping the crisis must have done a lot for your firm's fixed-income funds.
Our New Income fund ranked 22 out of 172 similar funds in 2007, returning 6.3%, versus 4.5% for the average fund. The most telling stat is the return for the worst fund in the group -- down 7.9%. I can guarantee that that fund was holding a lot of subprime.

Why was it so hard for others to see the risks?
Some people saw this coming. But it's hard to pull back from a market that's booming. Many people searching for yield felt pressure to buy securities they didn't understand. Bottom line: If you can't explain it, don't buy it. That's just common sense.