The subprime crisis

Right now we are experiencing what some are calling a credit crunch – a seizure in the capital markets – that is unprecedented in my career in its depth and duration. Economic growth in the US is clearly slowing – I'd say there's probably an even chance of at least a mild recession in the first half of the year. Consumers are showing increasing signs of household financial stress. Oil has gone over $100 a barrel for the first time and the most recent jobs report was a disappointment, to be polite.

These are the facts. They tell us something, though not everything, about where we are right now, and where we might be in the coming months. They are less meaningful in regard to our longer-term future. One of our greatest frustrations at times like these is that we want instant solutions. Market participants, policy leaders, consumers, investors, all want to know what can be done to fix what's wrong and make it all OK again. You can be sure that I've given this a lot of thought, and talked to a lot of very smart people, inside and outside our company, and I've come to two conclusions:

First, I do not believe there is a quick or easy fix to problems in our economy and financial markets that have been building for some time. I told our local Chamber of Commerce in Charlotte last month that what is required is time, and probably some more pain. My view on that hasn't changed. We are currently projecting just under one percent annualized GDP growth in the US in the first half of 2008.

Second, I remain extremely optimistic about the long-term prospects for the US economy. The US continues to be head and shoulders above the world in the fundamental strength and flexibility of its economy – the quality of our higher education infrastructure and the creativity and inventiveness of our entrepreneurs. Other nations are advancing – a competitive development we should welcome. But we continue to compete from a position of great strength. We believe we will see US GDP growth accelerate in the second half of the year to finish 2008 at 2.2 percent. And we expect the US to return to trendline growth in 2009.

In the meantime, our great task is to learn from our current situation, make the changes that will help us better balance economic growth and stability in the future, and get back on a path to economic growth as quickly as possible.

Low rates
The history of the ‘Great Credit Crunch’ of 2007 has been told and re-told many times. I won't give it the full treatment here but I will say that, as with most financial crises, this one had many parents. Historically, low interest rates, sustained over a long period of time, contributed to a flood of liquidity in the markets. As money to lend became cheap and available, many retail mortgage providers began to create innovative mortgage products that essentially increased borrowers' leverage, especially in the subprime markets.

At the same time retail mortgage providers were innovating, so were investment bankers. Accelerating innovation in the global capital markets, spurred on by the rapid advance of information technology, led to an explosion of highly complex, and often opaque, asset-backed securities, including new forms of derivatives, structured investment vehicles, collateralized debt obligations, etcetera.

The appropriate values or risk ratings of these instruments were exceedingly difficult to determine. In practice, as long as the housing markets, which provided the underlying assets on which the values were based, were stable or rising, pricing became a ‘follow-the-leader’ exercise, in which prices and risk ratings were assigned based on similar issues that had come before.
Debt ratings agencies' methodologies for assigning securities risk struggled to keep up with the rapid innovation and proliferation of product in the market. As of last July, for example, 75 percent of subprime residential mortgage backed securities were rated AAA, and only seven percent were rated BBB or lower. The reason is simple – subprime or not, home values and default rates were still relatively stable.

The availability of these investments, and the consistency of their performance, of course, resulted in ever more funds pouring into the market, feeding the cycle, and the bubble that was building in the housing markets.
When default rates began to rise, causing a couple of hedge funds to default in early summer, the credit markets seized up completely. Trading came to a halt, as no one really knew how to value the paper. In the fall, the ratings agencies aggressively downgraded many of these issues as a group, forcing bondholders (including Bank of America) to write down the value of their portfolios. And that's where we stand today.

One important question being asked in financial services today is whether the entire ‘originate-to-distribute’ model has been discredited for banks. I don't think so. Just as the bursting of the Internet bubble in 2001 was not the end of the Internet, the credit crunch of 2007 will not be the end of mortgage finance.
Rapid innovation can always cause complex systems to go out of balance and break down. But the basic idea that banks can better manage and distribute risk by securitizing financial assets has created extraordinary growth and stability over the past 20 years, for the financial sector and for the global economy. The forms this activity takes will be simpler, but it will continue.

No pain, no gain
I said earlier that time and more pain would be needed to return the credit markets to more of a ‘normal’ state. There are a few other steps that will be helpful. First, we need to re-establish confidence in the credit markets. This largely means increasing transparency in accounting for structured investments, and firms that invest in them, and also a return to simpler, more traditional structures that are easier to value. Innovation will continue, but new products will be held to a higher standard of transparency – and debt ratings agencies will develop methodologies that more accurately provide risk and pricing information for new forms of securities.

Second, financial service companies can work on their own and with partners in government to keep as many homeowners as possible in their homes. Most lenders and servicers recognize that flexibility often provides a higher long-term return than foreclosure. That's why lenders often spend so much time, money and effort working with borrowers to avoid foreclosure. But we have to be careful in these efforts. Depending on how they're structured, plans to mandate renegotiations of loan terms have the potential to undermine the viability of the secondary market.

Investors will hesitate to buy securities if they are not confident that the terms of the contracts are binding. This result would decrease funding opportunities for the entire market. It's easier for banks to renegotiate through their own servicing arms where they still own the loans, but it gets complicated when investors, borrowers and servicers have to enter into what is essentially a three-way negotiation. We believe the HOPE NOW program, as outlined by Secretary Paulson, creates a balanced approach that will prevent the potential for a broad market failure – but also will adequately protect the interests of servicers and investors.

Third, we all need to be willing to deal with our own challenges. Central bankers will step in when possible to protect the markets from the most severe consequences. But companies on the hook for past decisions need to find solutions in the private sector, and not look to governments for help. This is what many companies that have required capital infusions have done, and we think they'll be better off in the long run.