As a former refugee of the commercial banking meltdown of the mid-1980s, I can’t help but hear some echoes of that period in the current fallout from the collapse of the subprime mortgage market bubble. Hopefully, we won’t repeat the mistakes that were made then in adopting the selective bailout procedures, the “too big to fail” strategies, the moral hazard practices, and the “we know it all” attitudes assumed by the regulators of that era that converted a $10 billion problem into an $800 billion debacle, much of it centered in Texas. I am pretty far removed from all of the surrounding issues now, but it seems to me that, so far, Federal Reserve Chairman Bernanke has played his cards just about right, supplying liquidity through open market operations, signaling support as a lender of last resort through the discount window, and refraining from lowering federal fund rate targets. And the last thing we need to do is increase the size cap for mortgages purchased by Fannie Mae and Freddie Mac, institutions which are a large part of our problem in the first place.
As some have noted, this may be the first real test of the “new marketplace” of securitized debt obligations and segmented risk tranches that, however efficient in terms of allocation of risk, are very complicated to analyze from and underwriting standpoint and even more difficult to track in terms of ownership. In effect, in large measure we have separated the underlying business transaction from its ultimate financing source, thereby increasing the risk of metastasizing the problem. In the end, there will no doubt be more pain and some major corporate failures, but such is the price of the market discipline necessary to prevent a much larger meltdown.