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Monday, August 20, 2007
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Shifting blame from subprime loans
by Stephen Butler
A mortgage company owner said he didn't know of one single home
refinancing in which the borrower didn't take at least some amount
of equity out to spend. Not a single one.
The obsession with subprime mortgages and the wreckage they supposedly
have caused to stock prices around the world suggests that this
is yet another example of misplaced blame in the financial services
industry.
For those who bother to follow industry gossip, James Cramer,
the TV financial host, had what was described as a "meltdown"
two weeks ago and wound up screaming about Fed Chairman Ben Bernanke's
incompetence for not cutting interest rates to save the mortgage
industry.
We've been here before.
In the 1980s, the real estate industry that had filled America
with empty new buildings (doubling in 10 years the amount of commercial
space created from 1776 to 1976) blamed the drop in real estate
values on changes in the tax law.
The interesting aspect of today's mortgage market is the extent
to which a simple collection of loans has been carved up into
subsets that involve lower and higher rates of risk. The high
risk or subprime borrowers, of course, pay a lot more interest,
and these loans have been bought by those bankrupt hedge funds
we now are reading about.
The hedge funds themselves borrowed money to buy these loans,
so the actual investors in the hedge funds were just people who
had made, in effect, a 10 percent down payment on what was a huge
purchase of home loans.
The money borrowed to buy all those loans was, to put it in simple
terms, an adjustable-rate loan, which meant that the hedge fund
investors made money only as long as the interest coming in from
the home mortgages was more than enough to cover the interest
they had to pay on what had been borrowed to buy the loans.
Leverage works both ways: If you buy something worth $100,000
with a $10,000 down payment, your $10,000 of equity is wiped out
if the value of what you bought drops to $90,000. All those loans
bought with Other People's Money become worthless, temporarily,
as homeowners who made no down payment just walked away from the
homes they bought.
Unlike a local banker, who can walk up the street and sell the
home, nobody knows right now who is actually going to repossess
those homes to pay off at least a portion of the defaulted mortgage.
"Who actually owns the loan?" is the question that
has Wall Street scratching its collective head.
The subprime mortgage market, although huge in dollar amounts,
represents an extremely thin sliver of all the money loaned around
the world.
Even in this country, it amounts to peanuts, especially compared
with credit card default statistics
So, why is everyone so alarmed?
Could the focus on subprime mortgages be masking more disturbing
fundamentals that could better foretell what might be just around
the corner?
Most people are still employed and making good money. Corporate
profits are up, and stocks have gained 50 percent to 100 percent
during the past four and a half years.
What's to be concerned about?
Well, interest rates are rising because foreigners aren't buying
our debt as readily as they were six months ago. The last time
interest rates rose as quickly as they have recently was in 1987
-- just before that year's crash in October.
In Europe, interest rates are now at a seven-year high. If I
were the Chinese, I might be inclined to buy some French or German
government bonds at those higher interest rates and skip the next
auction of U.S. treasury bonds. That is effectively what has been
happening lately.
Nothing our Federal Reserve can do will change these fundamentals.
Supply and demand will raise interest rates enough to get those
bonds sold. If anything, an attempt to reduce interest rates will
just make the problem worse.
Laying blame on the mortgage industry masks the fact that we
have had massive consumer spending fueled by home equity loans
coupled with unprecedented debt levels in government.
Economists who predict a recession and market crash have had
it pegged for 2008. I'm a little more optimistic than some, but
I find myself leaning toward bond funds and large-company, dividend-paying
funds when I tamper with (i.e. rebalance) my investments these
days.
I'm thinking, "What if these guys are right?"
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