Dilution Was No Solution

March 24, 2008

Independent Commentary from Interlake Capital Management, LLC

Reflecting on the last few years--and especially the last few months--in the financial markets, one of the more remarkable subplots was just how convinced many participant-observers were that what started in subprime would stay there. The notion of "containment" never struck us as particularly plausible, but it sustained a furious bull run through mid-July, 2007.

Though his Harper's piece isn't exactly news anymore (it appeared in the February issue), Eric Janszen captured the essence of the problem as well as anyone. Here's our favorite passage from a very good essay (emphasis added in bold):
The U.S. mortgage crisis has been labeled a "subprime mortgage crisis," but subprime mortgages were only a sideshow that appeared late, as the housing-bubble credit machine ran out of creditworthy borrowers. The main event was the hyperinflation of home prices. Risks are embedded in price and lurk as defaults. Even after the faith that supported a bubble recedes, false beliefs continue to obscure cause and effect as the crisis unfolds.

Consider the chemical industry of forty years ago, back when such pollutants as PCBs were dumped into the air and water with little or no regulation. For years, the mantra of the industry was "the solution to pollution is dilution." Mixing toxins with vast quantities of air and water was supposed to neutralize them. Many decades later, with our plagues of hermaphrodite frogs, poisoned ground water, and mysterious cancers, the mistake in that logic is plain. Modern bankers, however, have carried this mistake into the world of finance. As more and more loans with a high risk of default were made from the late 1990s to the summer of 2007, the shared level of credit risk increased throughout the global financial system.

Think of that enormous risk as economic poison. In theory, those risk pollutants have been diluted in the oceanic vastness of the world's debt markets; thanks to the magic of securitization, they are made nontoxic and so pose no systemic risk. In reality, credit pollutants pose the same kind of threat to our economy as chemical toxins do to our environment. Like their chemical counterparts, they tend to concentrate in the weakest and most vulnerable parts of the financial system, and that's where the toxic effects show up first: the subprime mortgage market collapse is essentially the Love Canal of our ongoing risk-pollution disaster.
The point here is interdependence, awareness of which never should have deserted investors. But it did. And some very high prices have been paid for such willful ignorance of the defining characteristic of modern life.

Eric Janszen, "The next bubble: Priming the markets for tomorrow's big crash," Harper's, February, 2008

See also: Risk Pollution, April 2006 when current problems were forecast in detail.