August 14, 2007

THERE'S STILL A MARKET FOR TULIPS:

When the Dust Settles (SEBASTIAN MALLABY, August 14, 2007, The Washington Post)

The meltdown in financial markets may seem scary or mysterious, but it's part of a time-honored story.

In Chapter One, a new financial instrument makes capital available to a new class of borrower, and the result is profits for the innovator along with gains for consumers.

In Chapter Two, a group of not-sosmart investors misunderstands the novel instrument and bids its price up too enthusiastically; when the inevitable bust follows, the innovation is denounced as inherently dangerous.

Then, in Chapter Three, the complaints blow over. The not-so-smart investors learn their lesson and the new instrument stabilizes. Financial innovation turns out to be beneficial without being scary, but by that time another newfangled instrument has emerged to frighten people, and finance is hauled before the court of public opinion — again.

This is likely to be the story with the current subprime mortgage meltdown, just as it was with subprime's close cousin, the junk bond.

Posted by Orrin Judd at August 14, 2007 7:41 AM
Comments

When interest rates began to go down in the mid-80s, and again in the mid-90s, junk bonds were a great investment. Who wouldn't want to own a bond paying 9-12%, when bank rates were half (or less)? And most of these companies weren't 'junk'.

Owning Washington Mutual and Countrywide Financial was a good thing, until about 9 months ago. And it will be time to buy them again, probably in about 3-6 months.

Posted by: ratbert at August 14, 2007 4:23 PM

It won't even take that long to get WaMu and CFC to be good investments again. All the financial markets are waiting for, right now, is information on who has subprime mortgages buried deep in the portfolio. Yesterday, you saw a whole bunch of folks like Goldman Sachs announce their exposure, so that discovery process has already started.

And since Bernanke and the Fed now have no choice BUT to cut interest rates, those subprime lenders will have an easier route toward respectability going forward.

Posted by: Brad S at August 14, 2007 5:06 PM

Mallaby elegantly spelled out the Wall Street cycle of innovation. It's build on complexity (no one understands the new vehicle) and profitability (because it's complex, fat spreads can be included).

The first use of this I saw were the various limited partnerships (oil, real estate), later on it was zero coupon bonds, GNMAs, options, futures, junk bonds and then hedge funds.

Posted by: Kurt Brouwer at August 14, 2007 5:56 PM
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