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3 SUBPRIME
ICEBERG A YEAR LATER And the band played
on By Julian Delasantellis
How appropriate it is that paper is the
traditional gift of choice in celebration of a
first anniversary. It was one year ago that the
markets consummated their unhappy shotgun union
with what has become known as the subprime crisis.
It was one year ago, on March 6, 2007,
that I first wrote about the phenomenon on this
site, in my article, Rocking the subprime house of
cards. The appropriateness of paper to
celebrate this milestone is, of course, that the
subprime mortgages, indeed, the entire subprime
industry, once thought to be solid and
substantial, possessing real worth for both
borrowers and lenders, is proving to be made of
less actual value than the scraps of paper
handed out by sidewalk street
hawkers and then promptly thrown into the gutter.
The banns for the doleful union of the
markets and subprime were published on February 7
last year, as London-based HSBC Holdings issued to
investors its first ever profit warning, arising
from the problems with subprime mortgages at its
US Household Bank subsidiary. Still, just then it
did not seem to affect matters in the markets all
that much. From February 7 to February 26 the
S&P 500 Index lost a total of 65 cents (or
0.65 point). Markets are always said to be
climbing walls of worry, to be rallying amid
seemingly bad news, and whatever the curious HSBC
news actually meant, it didn’t seem likely that
there was any chance that it was going to have
sufficiently negative import to derail the
decade’s great bull runs in stocks, and especially
in real estate.
It was on February 27 that
the dam broke. Western investors awoke to find
themselves in the midst of a severe global equity
market selloff, one that began with a one-day 8.8%
loss in the Shanghai Stock Exchange’s A-share
market for yuan-denominated shares. On Wall
Street, the damage was a Dow Jones 416 point, (the
worst nominal point decline since the day trading
resumed after 9/11), 3.3% decline.
Yellow peril Equating
coincidence with causation, the Western media
heaped all the blame where it traditionally does,
on foreigners, on the yellow peril, on the Chinese
selloff.
In that first article, I opined
that it probably wasn’t China that caused the
worldwide selloff. The Chinese market could come
back from its losses (which it did, rising almost
2.5 times before getting caught in autumn’s world
equity market downdraft) but, if the 25% to 33% of
all 2005-06 mortgage borrowers who took out
subprime loans didn’t pay them back, the losses in
the markets would be a lot worse than 9%.
As I wrote then:
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.
And so began the
market’s financial, and my journalistic,
relationship with the subprimes. I’m not going to
say I was the first on the subprime beat, others,
among them some in the class of perennial market
pessimists that I like to call permabears, were
warning about it well before me. But, that spring,
as Federal Reserve chairman Ben Bernanke was
appearing before Congress reassuring the world
that there was nothing really to worry about with
the subprimes, at least readers of my column here
at Asia Times Online, along with those who read
Henry C K Liu and Chan Akya, had dissenting voices
that countered the rest of the financial media’s
incessant screaming buy-buy-buy until you drop and
die mentality.
At first, as late winter
turned to spring, it might have appeared that the
optimists were right. World stockmarkets quickly
recovered and recommenced their rally; an HSBC
flunky wrote in to Asia Times Online and said
that, even despite the problems I referenced in my
article, the institution was still profitable (not
that it helped much; HSBC stock is down 15% from
early February of last year, and on Monday it
announced US$17 billion of new, subprime related
writedowns, on top of the $3.5 billion it
announced late last year.)
It was in July
of last year that the pain really started, with
the collapse of two of Bear Stearns’ most
aggressive subprime based hedge funds, the
High-Grade Structured Credit Fund and the
High-Grade Structured Credit Enhanced Leveraged
Fund. In late July and early August, liquidity
absolutely gushed out of the credit markets, and
it’s never really returned. On CNBC they measured
Jim Cramer for a straitjacket, and at the Federal
Reserve, Ben Bernanke, who in 2002 said that the
Federal Reserve could, if necessary, drop dollar
bills out of a helicopter to fight deflation,
donned his leather bomber jacket and aviator
sunglasses and flew towards Wall Street.
At the Monetary Policy Forum, a hastily
organized joint Wall Street/academia conference
called last Friday, four prominent economists,
including Goldman Sachs chief economist Dr Jan
Hatzius wrote that, however bad most people
thought that things were going to get, in
actuality, they were going to get a lot worse. (On
February 6, Prejudice, blame and the US
way I described how conservative US
telepundit Ben Stein claimed that Hatzius’
November 2007 prediction that there was a 50-50
chance for a recession in the US this year was
only a ruse to add profits to Goldman’s short
subprime trading book. Good call, Ben.)
Dow selloff Calling for total
subprime losses in the neighborhood of $400
billion, and, more importantly, the subprime
losses leading to a pullback of lending by the
capital markets to the real economy in the
neighborhood of $900 billion, their warnings were
a major contributing factor to Friday’s 315-point
selloff in the Dow Jones Industrial Average.
Hatzius et al described how the
perceptions and projections of the ultimate
severity of the problem were at first relatively
optimistic, but have become bleaker all the time.
Conventional estimates of the likely
mortgage credit losses over the next few years
rose sharply during 2007. As recently as July
2007, Federal Reserve chairman Bernanke noted
that losses on subprime mortgages could total
$50-$100 billion. Given typical estimates of the
distribution of total losses between subprime
and other mortgages, this number corresponds to
overall losses of less than $150 billion. By the
end of 2007, most mortgage credit modelers
believed that total losses will be substantially
higher. For example, by December 2007, Lehman
Brothers (2007) was estimating that credit
losses on the currently outstanding stock of
mortgages will total $250 billion in their
baseline scenario of a 15% peak-to-trough home
price drop and $320 billion in a stress scenario
with a 30% drop. Similarly, as of late November
Goldman Sachs (2007) was estimating mortgage
losses of $243 billion in their baseline
scenario and $495 billion in a stress scenario.
In fact, during Congressional testimony on
January 17, chairman Bernanke admitted that
losses could amount to several multiples of
[$100 billion] as we go forward and the
delinquency and foreclosure rates
rise.
In this past year I’ve written
over 25 times for Asia Times Online on the
subprime beat. It was on November 27 (Countrywide exposes lost
virginity) that I explained why the
problem keeps getting worse:
Until the entire subprime problem,
both with the mortgages and the Wall Street
derivatives that emerged out of them, is
comprehensively addressed, the problem will
continue to get worse. The nature of the problem
today guarantees that it will be worse tomorrow,
worse still the day after that. Waiting for the
application of the traditional laissez-faire
tonic for financial panics, allowing prices to
fall so far so as to tempt demand back into the
market, is a prescription for a whole lot of
pain in these interconnected, over-leveraged
markets. It makes little or no sense to attempt
to speculate as to the total dollar size of the
crisis right now because no one is now even
close to proposing a realistic solution to the
problem; by the time realistic solutions are
proposed, maybe next year, maybe with a new US
president in 2009, the problem will be much
worse.
The reason the problem keeps
getting worse all the time is that this crisis is
not a static event, but a dynamic, negative
feedback loop process gaining a frightful momentum
all the time.
The core issue here is that
every subprime property foreclosed upon and then
thrown back onto the market with a foreclosure
auction adds real estate supply and thus depresses
prices, which makes it impossible for the next
subprime borrower to re-finance, so he defaults
and his property gets thrown onto the already
sodden market - on it goes. By July, we may wish
that things were as good as Hatzius et al just
warned they would be.
Looking back over
the past year, the thing that surprises me the
most is just how unsurprising this whole thing has
been. Put money into a system, as happened in the
financial markets up until this crisis began, and
you get one effect - take it out, and it’s the
opposite. Not expecting this crisis to have
developed as it has is like throwing a ball in the
air, turning away for a moment, and then being
surprised that the ball is then closer to the
ground when you turn back.
Equally
unsurprising is what a poor job the American media
elite has done in getting the nation to understand
this crisis, probably because to expect the media
to do so is a textbook example of the blind
leading the blind.
Wrong name, wrong
diagnosis Early on, the media tagged this
phenomenon as the subprime crisis (instead of the
probably more accurate moniker of the structured
finance crisis), so it’s not all that surprising
that a lot of the analysis goes no further than
the property boundaries of the subprime borrowers.
In the days before subprime, it was common
knowledge that African-Americans and Latinos, even
those with credit scores equal or exceeding those
of white borrowers with similar income, faced
special hurdles in obtaining mortgage finance.
Therefore, when high interest subprime mortgages
began to be offered to minority borrowers in the
last 10 years these previously economically
disenfranchised prospective homeowners snapped
them up quick; at last, the American dream of home
ownership seemed to be within their grasp. In some
areas of the American South, up to 70% of mortgage
finance offered to minority borrowers was
subprime. According to the New York Times,
"Neighborhoods where the population is more than
80% non-white account for 65 % of all
(foreclosure) cases."
This association of
subprime with American minorities means that when
proposals are floated to assist subprime borrowers
(and, by extension, the banks and other financial
institutions that lent to them), they are
inevitably decried by populist demagogues in the
media, especially on right-wing talk radio, as
just another form of "welfare", which, of course,
whites never receive.
On Fox News, a guest
opined that the subprime crisis was a
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