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Commentary: Lessons From Credit Disasters Past


The subprime mortgage market is toast, at least for the foreseeable future. And now the turmoil at American Home Mortgage Investment Corp. (AHM)—which made loans to home buyers with decent credit—suggests that the troubles are spreading to the broader mortgage market. Fearing the worst, investors are nervously demanding higher rates for bonds from corporations with no direct subprime exposure.

But the history of the past 20 years indicates that the subprime debacle, as spectacular as it is likely to be, won't knock out the broader flow of credit in the economy. Since deregulation took hold in the 1980s, the U.S. has developed a financial system with a high degree of redundancy. Worthy corporate and individual borrowers have more than one avenue for raising funds. The financial system has become like the Internet: able to reroute credit around damaged sections with relative ease.

Take a look back at the "credit crunch" of the early 1990s. As big banks such as Citicorp, as it was called then, struggled with bad real estate debt, they cut back on lending. In particular, new bank loans to businesses virtually stopped in 1990 and did not resume until 1994.

But the credit crunch did not extend to the bond market. While banks kept their vaults closed, corporations raised almost $250 billion between 1990 and 1994 by issuing bonds. As a result, companies such as Wal-Mart Stores (WMT), which borrowed billions over this period, had the money needed for expansion.

Fast-forward to the dot-com crash of 2000-2002. The stock market plunge wiped out initial public offerings as a source of funding for companies. Venture capital investments dropped as well, from $107 billion in 2000 to only $22 billion in 2002. And borrowers defaulted on mountains of telecom bonds as companies such as Global Crossing (GLBC) and WorldCom declared bankruptcy. The high-yield bond market, which had funded many of the telecom startups, froze up.

But despite the financial devastation, the rest of the credit market kept functioning. Between 2000 and 2002, nonfinancial companies borrowed an additional $500 billion through the bond market. Households took out almost $1.2 trillion in mortgage debt and more than $250 billion in consumer credit, enabling them to keep spending despite the stock drop.

What's more, toward the end of 2002—less than six months after the WorldCom bankruptcy—the junk-bond market came back to life as the economy improved, defaults dropped, and savvy investors like Warren Buffett started buying junk. That helped growing young companies such as JetBlue Airways (JBLU) raise needed funds.

This experience offers three lessons. First, investors may shun for years an asset class hit by financial trauma—telecom stocks after the bust, say, or securities backed by subprime mortgages today. But after the initial shock wears off, they are willing to take risks with other types of assets.

Second, the credit markets can absorb defaults as a business cost as long as they are spread across a range of financial players. The bonds of WorldCom, when it declared bankruptcy, were not concentrated in any one financial institution. Similarly, the damage from subprime mortgages seems to be widely distributed so far, including globally. On July 27, Oddo & Cie, a French money manager, said it would close down three funds with assets of over $1 billion because of subprime-related losses—bad news for French investors, but good news for the health of the financial markets.

The final lesson is the importance of a strong economy. It would have been much harder for the junk-bond market to recover in 2003 if gross domestic product growth had not accelerated, lowering the risk of lending. In the same way, the biggest danger to the credit markets today is an economic slowdown that hits corporate profits and homeowner incomes, which would lead to more defaults.

Financial regulators have long questioned whether the increased complexity and globalization of the financial markets have made them more or less unstable. Perhaps the answer is both: Credit blowups are more likely than ever, but there are more ways to get around them. This may be scant comfort to investors waiting for the next piece of bad news, but it makes all the difference in the long run.

By Michael Mandel


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