Subprime Credit: The Evolution of a Market

About once every decade or so economists get to witness the evolution of a credit market. In the 1970s there were mutual funds, in the 1990s there were high yield bonds, and today we have subprime lending. How do we establish a framework for a market that allows itself to undergo a quiet evolution but ends in speculation and credit revulsion? America's latest credit cycle, subprime lending, is not a unique experience but rather the latest variation of a traditional cycle of innovation, excess, and correction that is compounded by public policy laxity and followed by overreaction. Indeed, there is little that is new or creative in the whole subprime saga. This is disappointing because the subprime credit patterns we observe are so typical that they suggest much of the recent experience could have been avoided. This provides a simple analytical framework for the sub-prime credit market. It suggests that public policy actions, taken as if the subprime lending is simply a matter of speculative excess, fail to properly address the dynamic of credit markets that we have witnessed in the financial market over the last thirty years.Business Economics (2008) 43, 14–22; doi:10.2145/20080302