The subprime mortgage market—high-risk loans to borrowers with poor credit histories—has expanded rapidly over the last few years, from five percent of all mortgage lending a decade ago to about twenty percent of all mortgage lending today. There are about $1.3 trillion worth of loans outstanding, and over $600 billion worth of new ones were made in 2005 alone.

This expansion has now shifted into reverse. The boom is over; the bust is accelerating; enthusiasm has been replaced by fear—recriminations and punishment will soon follow.

The reasons for this collapse seem predictable in retrospect. Many subprime mortgages feature adjustable interest rates that (like the promotional introductory rates on some credit cards) start artificially low and ratchet up after an initial honeymoon period. Borrowers may make little if any down payment. As long as the housing market stayed hot and interest rates remained relatively low, borrowers made their payments and lenders pocketed high profits. But today’s subprime borrowers are facing higher interest rates at the same time as a cooling housing market puts downward pressure on the value of their equity. Many are finding themselves unable to make the payments.

It all puts me in mind of a saying of one of my old banking mentors:

Managers, investors, and traders are doubtless now reflecting, “I couldn’t really imagine it could get this bad.” Their limited imaginations are typical of credit booms.

Now many subprime mortgage lenders have failed, and others announced they are leaving the business. Stock prices of specialist subprime lenders have moved dramatically—a fall of 90 percent for New Century Financial from its 52-week high, for example, along with a federal criminal inquiry into its accounting and securities trading. Fremont General is down 74 percent and the FDIC has put a regulatory clamp-down on its operations. NovaStar Financial is down 87 percent and has announced that it expects little or no taxable income over the next five years.

Subprime mortgage delinquencies and defaults have gone to unexpectedly high levels with unexpected speed, a lot of computerized credit behavior models notwithstanding. Delinquent home equity loans are rumored to be attracting secondary market bids of from 15 to 25 cents on the dollar.

Credit standards are tightening for consumers with lower credit ratings, financing for the subprime lenders themselves, and for securitizations, reducing liquidity for all of them. Banking regulators have issued new, tighter credit “guidance.” From now on, “lenders who offer adjustable-rate mortgages [to borrowers with poor credit] will have to consider whether the borrower can afford the higher payment that results when interest rates go up.” This intervention comes too late to help, but probably in time to help push the market further down.

For the subprime mortgage market, the risk has already happened. Now it is a matter of paying.

The current rhetoric of the business press reinforces the downward momentum: “meltdown in the subprime market,” “subprime wreckage,” “the maelstrom in the market for subprime mortgages,” “the plunge in subprime mortgages,” “housing bubble: toil and trouble,” and so on.

It all puts me in mind of a saying of one of my old banking mentors: ‘Risk is the price you never thought you would have to pay.’

Recent financial commentary has turned quite pessimistic, for example: “This is an area that will consistently worsen…we are in the early phase of it.” “The rapid, high-profile demise of the pure-play subprime lending industry.” And New Century is “more likely to enter the death spiral we had feared.”

Ironically, New Century still refers to itself on its web site as “a new shade of blue chip…with consistent and strong financial performance…the first of a new breed of companies.” Under current circumstances, updating the web site is probably not a high priority.

In addition to the troubles of the lenders, we must consider the driving financial engine of the subprime mortgage boom: securitization of subprime mortgage pools through tranched, senior-subordinated structured bonds, designed and given public credit ratings based on financial models.

The junior tranches of these subprime mortgage-backed securities are highly sensitive to worse-than-expected loan default rates and thus vulnerable to generating heavy losses. Subprime mortgage-backed securities are often themselves pooled into collateralized debt obligations or “CDOs” and further tranched, thus creating subordinated securities that are hyper-leveraged to credit risk.

Analysts are now said to be scrambling to try to figure out who holds these risky investments—where did they go? What will happen to these holders and how will they react as the subprime bust proceeds? These essential questions must put us in mind of Stanton’s Law, formulated by Tom Stanton of Johns Hopkins University:

“Risk always migrates to the hands least competent to manage it.”

If Stanton’s Law prevails, who will be taking the losses?

This cycle of boom and bust displays the classic pattern of recurring credit over-expansions, which repeat over the decades and the centuries, as memorably described by Charles Kindleberger in Manias, Panics and Crashes (see the 5^th edition, updated by Robert Z. Aliber, 2005).

Such over-expansions are credit celebrations typically based on optimism and a euphoric belief in the ever-rising price of some asset class—in this case, houses and condominiums. They are inevitably followed by a hangover of defaults, failures, dispossession of widows and orphans, and the probability of a late cycle regulatory and political reaction.

As the great student of finance, Walter Bagehot, observed in 1873:

“The mercantile community will have been unusually fortunate if during the period of rising prices it has not made great mistakes.”

In the extended period of rapid and seemingly inevitable increases in house prices, the subprime mortgage finance community, optimistic and enjoying big commissions and bonuses, with their companies’ share prices rising, took on more risk than they thought and made some significant mistakes.

In addition to mistakes, as Kindleberger further observed, “The implosion of an asset price bubble always leads to the discovery of fraud and swindles.” This will no doubt also be the case with the subprime mortgages. National Mortgage News has just introduced a new weekly “Compliance and Fraud Newsletter,” responding to what it calls “the explosion of mortgage fraud.”

It is easy to imagine that this will lead to a political overreaction. Perhaps we will have the “Sarbanes-Oxley Act of Mortgage Finance,” or some similar punishing of the innocent along with the guilty. If so, it will be another part of “the price you never thought you would have to pay.”

Alex J. Pollock is a Resident Fellow at the American Enterprise Institute. He served for twelve years as president and chief executive officer of the Federal Home Loan Bank of Chicago.