Why did the housing mess clobber my 401k?

John W. Schoen • Profile • E-mail

Part of the blame for last week's stock market plunge was pegged to jitters about the ongoing fallout from the housing mess. Which has some readers wondering: Why should the stocks in my retirement fund get clobbered just because some bankers made a bunch of bad loans to home buyers who couldn't pay them back?

Why all the worry about the housing market? It gets what it gets if the bank loses money because of being greedy. … I think we as American people and stockholders in 401k accounts should not lose our assets because lenders wanted more money, and they let people that could not afford the payment get a mortgage. They should have to pay for their stupid action.
— M. M. Welch, W.Va.

Plenty of players in the mortgage lending frenzy have already gotten burned. Dozens of the companies that went overboard lending to people who couldn’t handle their monthly payments have already paid the price: going out of business after being swamped by losses from an avalanche of bad loans that went bust. In many cases, the investors who bought shares in these “subprime” lenders also lost money.

More recently, a lot of Wall Street’s best and brightest got burned after putting a little too much faith in their computer models — which told them that they could insulate themselves from the risk of lending to people with bad credit. Those computer models — and the increasingly complex financial structures used to churn out paper that was sold to investors by the boatload — are now creating huge losses for some Wall Street firms that bought and sold these so-called “mortgage-backed securities.” And some of the people who bought these bonds — including hedge funds who gobbled them up — are also turning out to be big losers.

The problem is that when it comes to the financial markets, we all have to drink from the same well. Though much of the loss has been felt most heavily by the principal actors in this play, the paper they churned eventually flows into the same financial market that hosts your 401(k) account. Though stocks and bonds often march to different drummers, trouble in the bond market — where all these rotting mortgage pools ended up — can spill over in the stock market. One reason for the rapidly rising prices paid for stocks you may hold in your retirement account, for example, was widespread belief in the assurances from the Wall Street computer wizards that they had come up with new ways to control lending risk.

For a few years there, it looked like these new Risk Reduction wizards were right. Investors began buying up all kinds of risky paper – from subprime mortgage pools to debt from Third World countries — with little more insurance (in the form of higher interest rates) than they got from the safest investments like U.S. Treasury bonds. It was as if somehow, in this new world of interest rate swaps, credit derivatives and risk management models, a basic law of finance had been repealed: that you should always get paid substantially higher interest rates to protect yourself from borrowers who had a worse-than-average track record of not paying your money back.

A number of market watchers have been warning that this could end badly. The so-called “credit spread” — the difference between interest rates on the safest and riskiest bonds — has shrunk sharply in the past three or four years. Now, as investors rethink the assurances from the risk managers, the markets are getting more cautious – and demanding higher interest rates for risky paper. And when credit gets more expensive, that often hurts both stock and bond prices.

A lot depends on how much more bad news is lurking among the investment banks and hedge funds that may be holding bonds based on shaky loans. Since these hedge funds are not regulated, and don’t have to report their financial holdings like your 401(k) does, no one is quite sure just how much wider these mortgage–related losses will be. A lot also depends on how long before the housing market recovers — and just how many more subprime borrowers eventually have to throw in the towel and default on their loans. That process takes time to work through the system before the investors who bought bonds based on these mortgages take the final hit and report their losses.

It could be that the worst of the storm has passed. If the bond market continues to adjust — gradually — to a new view about the realities of risk, the markets could emerge from the latest downturn none the worse for wear.

The problem is that no one knows for sure what lies ahead. And if there’s one thing the financial markets hate, it’s that kind of uncertainty.

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