A big financial crisis spreads the notion that the interests of Wall Street differ from the interests of Main Street. The "liquidity crisis" of the past few weeks, with its difficult jargon and complex financial instruments, is a prime example. Unfortunately, the notion that the tumult represents a failure of markets is exactly the wrong lesson to take away from this experience.
In a nutshell, here's why.
In the past few years, mortgage lenders-ranging from the George Baileytype savings and loans to national lenders-developed loan options that allowed lots of families to buy homes who would not qualify under the traditional 20-percent down-payment mortgage. We'll call these "subprime" loans, even though the majority of the borrowers are today happily sitting in their homes, making payments, building equity and appreciating the joys (and woes) of homeownership. A minority of these borrowers made unwise purchases. Perhaps they could not afford the loans, or simply lost their jobs.
Some homeowners who were recipients of subprime loans now face foreclosures. They result in a family's losing a home. They also cost banks and local governments money. However, for each of these losers, a new homeowner emerges, who often gets a nice deal on a foreclosure. No real wealth is destroyed, and nothing to spawn a crisis emerges. And so, for the larger economy, the small increase in the foreclosure rate (nationwide just a few homes out of each thousand) is hardly a national crisis. So where's the problem?
After making the subprime loan, mortgage companies like to sell debt to other financial firms by packaging different kinds together, balancing the risk and return. An attractive debt package will include corporate loans, credit card debt and home mortgages-the last being the safest of the three.
The problem emerged once word got out that many home mortgage loans were going to foreclosure. But here's the thing. The problem isn't that lots of homes would foreclose. The problem is that nobody really knows how many homes will foreclose, and consequently how much less their packaged debt actually is worth. It was this uncertainty (not risk) that led investors to pull their money out of financial firms.
So, the problem isn't lots of foreclosures. It is that buyers of debt don't know how bad the problem might be. Here's where our financial system aids markets in resolving their problems. The Federal Reserve Bank responded by providing lower-cost loans to these banks until their losses could be sorted out. It's that simple. In the end, a crisis largely has been averted.
There's certainly more fallout to come from the subprime mess. Money will be harder to borrow, selling homes might get a bit more difficult, and the Federal Reserve might opt to ease money supply as a way to forestall a slowing economy.
So what's the lesson? Our financial markets work well-as the ongoing resolution to the current problems shows.
Hicks is director of the Bureau of Business Research at Ball State University. His column appears weekly. He can be reached at firstname.lastname@example.org.