High Risk Mortgages Disaster
U.S. Subprime Credit Crisis Sets Global Financial Markets on Fire
When crisis struck the financial markets last time, (that would be the infamous dot-com implosion from seven years ago), the events that unfolded were horrific, yet oddly easy to understand. A simple pattern was followed—greed first, panic second! Or, more specifically, first there was genuine excitement, then came greed and speculation, then a bubble of massive proportions, a loud “bang,” a stampede for the exits, and finally, a rather spectacular meltdown.
Parallels can be drawn between the dot.com crisis of 2000 and recent shenanigans in the credit market. Unfortunately, there are also quite a few unique characteristics to the credit market crisis we are dealing with now that are exponentially more dangerous.
It surely appears almost absurd that a rather obscure sub-sector in the U.S. housing market could have created such a mess, seemingly overnight, and with serious consequences no one expected or prepared for. These days, economic news read like obituaries, stock markets yo-yo up and down, while buy side investors have gone deep underground.
How and Why Did It Happen?
Those precious few, who have had the sense to pause and think, are asking identical questions. How could something like this happen? Why did it happen? And, more than anything else, what will it take to survive it this time? At the core of solving any problem is understanding it. To grasp fully how this particular snowball transformed into an avalanche, we need to travel back in time—seven years, to be precise.
When the technology sector collapsed in 2000, dragging down with it the global stock markets, red flags were raised indicating the U.S. economy was heading for a recession. To boost the country’s economic performance, the Federal Reserve began with unprecedented interest rate cuts, going as low as one percent by 2003, and maintaining that level for a full year. (For more information on historical interest rates in the U.S., please refer to the Federal Reserve statistical releases, which are updated daily and downloadable in various formats.)
Predictably, with inflation and interest rates at historic lows, borrowing bonanza soon ensued. Things were particularly hot in the U.S. real estate market. The American Dream finally became complete with homeownership being offered to anyone asking for a mortgage, including people with disastrous credit histories, or, the so-called subprime borrowers.
Not only were borrowers with lackluster credit records approved for obscene mortgage amounts, but these mortgages were also packaged better than candy, all with no downpayment, no interest, option payment mortgages, “piggy back” mortgages, and other similar types of extremely high-risk mortgage alternatives. Rules, caution, and risk management were thrown out the window.
But how can you blame a bloke knocking on a door of a friendly neighborhood banker and asking for a $500,000 mortgage based on income of $35,000 a year, and actually getting a “yes” for an answer? Are subprime lenders and foolish bankers the only ones to blame for what has happened? In two words or less—heck no!
As clocks around the globe clicked into the new millennium, the intriguing world of high finance has undergone a tremendous change. The technology, globalization and world trade have connected at unprecedented levels even the most abstruse markets to main financial arteries. The supply of capital appeared ceaseless, and with interest rates at bizarrely low levels, most of that capital came from something economists referred to as easy credit.
To use an analogy from the animal kingdom, compare the supply of capital/credit to a water well, and animals coming to drink from it to pension funds, insurance companies, and other similar pools of money. Once pension funds and insurance companies have had their fill and saturated their portfolios with cash, they handed it over to hedge funds and private equity firms in the everlasting pursuit of higher returns.
Then those guys turned around and began borrowing billions of additional dollars to keep the money machine running smoothly. Only, with so much money on their hands, traditional investing techniques simply would not do: speculators had to employ their imagination to meet their clients’ demands, growing more aggressive with each basis point in excess return.
So, they turned to devising complex investment vehicles, which, in this case, were really packaged and repackaged mortgage debt from all categories of borrowers in such a manner that the majority of risk components were allegedly diversified away. Or so everyone thought. However, the type of risk that no amount of packaging could slice off was the credit risk, along with the liquidity risk.
First signs of trouble erupted just as Americans were gearing for the 2006 holiday season. Subprime lenders had to admit that default rates among their customers have been rising at an alarming speed. Admittedly, that was hardly a surprise to anyone with even just a basic knowledge of macroeconomics. Since 2003, interest rates have increased from one percent to 5.25%, while the housing market had peaked and prices have been declining ever since. Also not surprisingly, subprime borrowers, by then drowning in debt, started doing what they did best—defaulting on their mortgage payments.
But, this sordid story did not stop with the collapse of the subprime lending market. What started as a local brush fire in December of last year, quickly spread around the globe, driving significantly down world stock and bond markets by the summer of 2007. And, while investors are still reeling from losses inflicted on their portfolios, there has been a new beast rearing its ugly head—fear of the global economic slowdown.
What Might Happen Next?
Macroeconomics offers a simple explanation of what might happen next. The supply of capital has come under almost unbearable pressure because of the decomposing subprime lending market in the U.S. With the limited supply of capital, many firms could be forced to scale down production by decreasing their labor force. With decreasing incomes, consumer spending is likely to be next on the chopping block. With fewer buyers of goods and services, corporate earnings will also head for a downturn, ultimately slowing down the overall economy and sending it into a recession.
At the moment, everyone's binoculars are focused on the Fed. One way to ease the pressure, at least temporarily, is to start lowering interest rates. The Fed did it seven years ago when the tech bubble burst, and it worked, at least initially. The situation now calls for more interest rate cuts, but not to the point of creating easy credit, yet again.
Next, hedge funds and private equity will have to face tougher regulation since those institutions have already proved they are not to be given free reigns. Surely, there is also bound to be an intense investigation into how subprime lenders managed to throw the rule book out the window and (almost) get away with it. However, whether these measures will be enough for investors to survive the long and unpleasant road to recovery, at this point, is anyone's guess.
