America’s latest credit cycle, subprime lending, is not a unique experience but rather the latest variation of a traditional cycle of innovation, excess and correction compounded by public policy laxity followed by overreaction. Indeed, there is very little new or creative in the whole subprime saga. This is disappointing because the subprime credit patterns we observe are so typical that they suggest much of the recent experience could have been avoided. In the end, the whole experience brings forth several core public policy issues that are more often avoided rather than faced.

Just as there are economic and credit cycles, financial and economic regulations have had their own cycles over the past hundred years. These cycles have consistently altered the tradeoff of reward and risk for market participants. The creation of the Federal Reserve in 1913 was in response to the Panic of 1907, and yet many economists argue that the Fed made the Great Depression, some 20-plus years later, deeper and longer than would otherwise have occurred. Geographic banking restrictions, originally intended to reduce the risk of bank failure and concentration, actually increased the risk of failure with the onset of accelerating inflation and higher interest rates in the late 1970s/early 1980s.

In this latest cycle, the conflict of weakening fundamentals, exemplified by diminishing housing affordability, combined with the price shock to speculators who could no longer find the greater fool, led to a quick unraveling of the credit cycle and a sharp downturn in previously assumed perpetual home price appreciation. For speculators and investors, decelerating prices were a shock to market expectations.

And we are already beginning to see the increase in regulatory oversight as negative outcomes of the downside of the credit cycle are being revealed.

The Most Dangerous Phase of the Credit Cycle: Reacting to "Feedback"

What makes this all so intriguing is that these housing and mortgage market movements are not from one stable equilibrium to another but, rather, often to a new matrix of prices and credit quite different than what was conceivable. Likewise, "feedback" -- or reaction -- from institutions and decisionmakers will likely generate results that were unanticipated just a few months ago.Why would decisions made in reaction to the feedback process represent the riskiest stage of the credit process? In the current subprime lending situation, we would recognize the process as being very fluid with many actors attempting to resolve the risk/reward tradeoff and the appropriate pricing for real assets (houses) and financial assets (mortgages and mortgage-backed securities). Private and policy actions taken at this time could either amplify or dampen the volatility of the market process.

Feedback from economic developments provides decisionmakers with information. Based on this information, leaders can decide to react, or not, to that information and alter their earlier decisions or the earlier framework for decisionmaking. Moreover, the decision not to change is also a choice. When the economy evolves, but institutions do not, the outcome is often stagnation (European and Japanese growth in recent years) or major upheaval (the breakup of the Soviet Union).

Policy Options

For subprime lending, private actors have a decision to make with respect to lending standards and the price of credit to allow for variations in the riskiness for subprime loans. Public policymakers have a choice on how to set standards on the quality and quantity of loans they will accept for federal forms of insurance or their portfolios.

If Federal policymakers and private lenders do not alter prior rules on subprime lending, then another credit cycle is likely. However, if lending guidelines are tightened too much, then a true credit crunch becomes more likely and the downdraft in the housing cycle will be amplified. Credit constraints will generate even greater rates of delinquencies and foreclosures. This credit reign of terror was the pattern for the high-yield bond market during the 1990-1992 period. In today’s cycle, we can see that the rapid rise in the net percentage of banks tightening standards sets up the preconditions for a rout if public policy amplifies the call for the exits.

Once again, the market is moving quickly to ration credit. For housing and mortgage markets, the credit dynamic today can be further complicated by policymakers. Federal authorities recently have issued guidance to tighten mortgage lending standards. Moreover, Freddie Mac has issued tighter guidelines on the subprime mortgages it will accept.

Unfortunately, this is all after the horse has left the barn. Tighter standards will make it more difficult for future buyers to qualify and, thereby, reduce the demand for homes. This accentuates the downward price momentum and, thereby, the upward swing in delinquencies. How much and how quickly do regulators raise credit standards to where they "should have been" without shutting out all transactions that might clear the existing overbuilt market? All this suggests that policymakers tread carefully, given the current below trend pace of economic growth.

Further, some policymakers in Washington suggest bailing out the delinquent borrowers. This creates a risky set of incentives and a hopelessly complicated set of regulations. How will government determine the truly unfortunate as compared to the simply speculative borrowers? Many subprime mortgage brokers are headed for failure, but then who will make up the payments to investors? Will future taxpayers be asked to pay interest on bonds to fund current speculators? If no new credit is forthcoming, then many homes and developments will not be finished, neighborhoods will take years to complete and community and personal stress will remain elevated for longer than is currently anticipated.

Conclusion

Today's interaction between finance and economics is a dynamic process with many unanticipated twists in the course of market adjustments. Too often, both private and public policymakers fail to heed the implications of change. Moreover, too much decisionmaking only considers the very first step in the process. Effective leadership must look down the road to anticipate the second and third turns to judge the effect of current decisions. Subprime lending is simply the latest example of a long history of such dynamic processes with uncertain outcomes and unanticipated results.

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