Sub-Prime Mortgage Market is the Lack of Experience

Another problem in the sub-prime mortgage market is the lack of experience. With no experience it is difficult to be precise (or even analytical) about how long it will last or how bad it will get. From the WSJ:

Participants in the complex world of debt tied to subprime mortgages may not be the rocket scientists they thought they were. But they have a problem rocket scientists appreciate: It's hard to precisely analyze something when the thing is moving.

Wall Street has been rocked as investors have found that many of the collateralized-debt obligations they bought were riskier than expected. CDOs are pooled-together debt instruments that sometimes hold subprime-backed bonds. When the housing downturn gathered steam, subprime delinquencies rose sharply, which is now hitting these instruments.

With the shuttering of two Bear Stearns hedge funds and recent moves by ratings services to cut ratings on billions of dollars of subprime-linked CDOs, market participants might better get the risks.

The problem is the U.S. housing market continues to deteriorate. Nobody knows when it will improve or how bad subprime losses can get. At the end of the first quarter, 5.1% of subprime mortgages were in foreclosure, up from 3.5% two years ago, the Mortgage Bankers Association says.

For a sense of how quickly foreclosures can rise, consider the 1980s Texas oil-patch bust. Back then, foreclosures in the state for all mortgages soared from less than 0.1% of all mortgages in 1981 to 1.9% by 1987. And that was based on mortgages to creditworthy borrowers. Many subprime borrowers never should have gotten loans this time.

The problem, Columbia Business School professor Christopher Mayer points out, is that Wall Street's experience with subprime mortgages isn't deep. Its experience with the exotic mortgages written in the late stages of the housing boom is essentially nonexistent. That makes their reaction to the housing downturn impossible to predict.

"This story is going to be going on for a long time," Mr. Mayer says. "There's no way to fast forward the process."