Page 3 of 3 Rocking the subprime house of
cards By Julian Delasantellis
reinforced. Soon, people were paying close
to $1 million for one-bedroom condos in San Diego
or Miami Beach, and they were happy to do so; they
thought they were getting a bargain. By 2005 and
2006, between 25% and 33% of all newly written US
mortgages were subprime, but this was thought to
be okay. The borrowers had their homes (or they
thought they did), the investors had their
high-yield securitized mortgage bonds, and
incumbent politicians
could point to the healthy home-ownership numbers
as proof that the mighty American dream still rang
strong and true.
Just about the time that
soaring real-estate prices were replacing
celebrity sex as the central obsession in the US
psyche, something funny happened. Price rises
slowed or stopped; in some of the hottest markets,
home prices actually began to decline. Between
June 2004 and June 2006, the US Federal Reserve
raised short-term loan rates 17 times. Starting at
1.25%, the Fed eventually drove them up to today's
5.25%.
Floating rate mortgages had their
rates tied to these Fed rates. For those mortgage
borrowers who only got into their homes by being
able to handle a floating rate payment that
started with the low payment implied by a 1.25%
Fed rate, this meant a big mortgage-payment
increase. These borrowers could barely qualify for
loans and then handle the payments calculated with
the low rates; when the mortgage payments were
recalculated to reflect the higher rates (were
"reset" in mortgage jargon), they would be unable
to pay the mortgage. The rise in mortgage interest
rates, along with the fact that in the areas where
the price appreciations had been the craziest,
prospective buyers soon realized that everybody in
the household up to and including the family pet
would have to work two or three jobs to generate
enough income to afford the payments inherent in
the $700,000 selling price of a two-bedroom
rambler, finally broke the back of US housing's
wild ride.
The warning flags have been
flying for months, but with every five-point rise
in the Dow index being wildly celebrated as
another glorious new record, another gushing
multiple orgasm in the fabulous orgy of US market
capitalism, the US media ignored the story that it
should have told in favor of the one it wanted to
tell.
On February 7, HSBC Holdings,
formerly called Hong Kong Shanghai Bank Corp,
warned of massive forthcoming losses, arising
mainly out of problems at its US subsidiary,
Household Bank, a leader in subprime lending.
Another big subprime lender, New Century
Financial, did the same. Along with the waves of
real-estate foreclosure notices now piling up in
the clerk of court offices in the former hot
markets, the markets slowly started to realize
what was, for the lenders anyway, a very
inconvenient truth: a lot of these mortgages were
never going to be paid back. A lot of major
financial institutions that had invested in
subprime mortgage debt, not just HSBC and New
Century, were looking at very serious
balance-sheet problems.
A lot of wags have
noticed that for the US stock market, bad news is
frequently treated as good news. Unemployment is
up, or industrial production is down, and stocks
rally (due to attendant possibility seen in these
reports of upcoming Fed interest-rate cuts).
However, when major financial institutions have
what are delicately called "liquidity issues" (ie,
their loans aren't being paid back - they have no
income), that is always bad news. What if the bank
defaults, declares bankruptcy? Other banks that it
had borrowed money from now won't be getting paid
back, they'll lose whatever income stream they
were receiving from the first bank. The same with
that bank's creditors, and then other banks and so
on.
This kind of cascading
financial catastrophe is often called a "contagion",
and with good reason. Like a virus, it can spread
and bankrupt the entire financial system. It
almost did in 1998, during the LTCM hedge-fund
crisis; in 1929,in an era when the worldwide financial
system was far less globalized and integrated than
it is today, after the Great Crash it actually
did, and so initiated the Great Depression of the
1930s.
Is it over? Not necessarily. Two
little-known indicators that more investors should
be cognizant of are what are called the VIX and
VXN indicators. (Put these letters in the stock
symbol line of your quote website; they should
come up - watch how their values move inversely to
stock prices.) Technically, what these two indices
measure is what is called stock-option volatility
(stock "beta", in jargon), but what they really
tell smart investors is just how much fear there
is in the markets. When these levels get very high
(roughly above 30 in both indices; after the
selling caused by the Enron corporate-management
scandals of 2002, the VXN actually topped out over
70), it indicates that the market has seen so much
fear-driven panic selling that, by the rules of
what is called contrarian investment philosophy,
stocks are due for a turnaround. As of the first
weekend in March, neither index had reached those
extreme levels.
So it's not China. It's
not Nancy Pelosi, it's not the Easter Bunny, nor
is it the War on Easter. It has been said that all
market psychology, all market movement, is a
continuous oscillation between the mental polar
opposites of optimism and pessimism, between greed
and fear, between Pollyanna and Cassandra. Since
at least the market rally that started in early
2003, optimistic Pollyanna has ruled the markets,
and greed has run rampant. As the markets wait for
Fed chairman Ben Bernanke to put on his best Donna
Reed mask to bail out the subprime lenders with
the Bailey family's honeymoon money, Cassandra and
her fear are ruling the day.
Note 1. Frank Capra's
1946 film It's a Wonderful Life starred
James Stewart as George Bailey and Donna Reed as
Mary Hatch Bailey. Julian
Delasantellis is a management consultant,
private investor and professor of international
business in the US state of Washington. He can be
reached at juliandelasantellis@yahoo.com.
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