Understanding the Subprime Mortgage Crisis

Our economy is in deep shit and like it or not – you’re sitting smack dab in the middle it.  Lots of people are asking the same questions:  “How the hell did we end up like this?”,   “Isn’t this just a Wall Street problem?” and “could this recession really effect me? – If so, how bad could things get?”    To fully understand why the U.S. economy is in such bad shape and getting worse, one of the things you need to do, is get a firm grip on understanding the Subprime Mortgage Crisis…

The prudent man’s rule when calculating how much one can afford to pay for a home without getting in over your head is typically no more than 3-4x your annual income. 

In 2005 (the peak of the United States housing bubble) the economy was booming, jobs were plentiful, consumers were spending and the real estate market was unstoppable. However, irresponsibly unnoticed the median home price had become six to nine times greater than median income.  That was the sign banks chose to ignore.  Despite this dislocation, lenders were tripping over themselves to make loans based on the unrealistic misconstrued concept that property values would always continue to soar.

Competition became so fierce among lenders they began seducing the unfortunates, people with bad debt, low paying jobs and sketchy credit histories.  Based on their less than adequate financials, this subprime underclass that had no business even buying property, had become mortgagors.  Both the lender and the buyer knew they couldn’t really afford that dream home – but what the hell, those teaser rates were just too good to ignore.

To better understand the “Subprime Crisis”

 DOWNLOAD THIS PRESENTATION

Enormous risks were being taken as American lending institutions continued to rapidly fuel what would eventually lead to today’s subprime mortgage crisis, credit crunch and the meltdown that is currently crippling the U.S. financial system.

During the boom, owners would draw from their rapidly growing home equity to pay their bills (including their mortgages).  Essentially, people -a lot of people, were making mortgage payments with funds borrowed agaist their home equity to pay the mortgage.  This twisted cycle of financial ineptitude worked just fine… that is, until the housing bubble started to burst.

In 2006, the real estate market was clearly headed south, by the 3rdquarter, foreclosure filings were up 45% from the year before and instead of putting tighter restrictions on mortgage loans, lenders continued to issue even more of these risky loans. WTF!!?

No matter how risky the loan or unreliable the applicant, the only thing mortgage brokers cared about was the commission they were receiving from the lender.  Lender’s on the other hand, needed the short-term profits they generated by re-branding these risky subprime mortgages into Mortgage-backed securities (MBS) and collateralized debt obligations (CDO) and selling them in the secondary market to third party investors. 

Since these underestimated MBS and CDO, that no one fully understood as much as well as they should have, carried such promise of high yield… corporate, individual and institutional investors backed up the truck, piling them up like too many eggs in a basket.   Once the real estate market started to fade, underlying mortgage assets declined and these people who were already stretched too thin could no longer afford to make payments. The holders of CDO and MBS faced significant losses causing the stock market to weaken significantly.

Realizing just how wide and deep this credit risk had spread, lending activity significantly cut back for individuals and corporations as money lenders increased spreads on higher interest rates since it was unclear how financial institutions would be effected.  This is what you hear referred to as a credit crunch.  Soon liquidity concerns over the high number of MBS drove central banks around the world to take action to provide funds to member banks to encourage lending to worthy borrowers and to restore faith in the commercial paper markets. The U.S. government also bailed-out key financial institutions, assuming significant additional financial commitments.

Seemingly overnight, the subprime crisis had begun to drag on the economy, pressuring growth. Fewer (and more expensive) loans resulted in decreased business investment and consumer spending. And as we break through record level inventories of homes on the market, the housing market continues its downward spiral from it’s 2005 highs. New home construction has been crippled on count of the abrupt reduction and shift in demand versus supply. 

Pay attention. The economy is under serious pressure and in significant trouble.  People, corporations and even banks cannot borrow money.  What you can borrow, comes with a very high price tag.  Without credit, the consumer is dead.  Without the consumer, the economy is dead.  Stock markets gain strength from earnings and growth, so when the consumer isn’t buying goods, services and new developments are debilitated from lack of funding, you can expect Wall Street to suffer.   Here comes the bad news… It’s going to get worse. Much worse.

Here in 2008 it’s the “Masters of the Universe” making the front page while they were brought humbly to their knees.  Lehman Brothers, Bear Stearns, Fannie Mae, Freddie Mac, AIG and other financial giants either went bankrupt, near bankcrupt or were left crippled.  Don’t think for a second that this is just a high roller “Wall Street problem”…  This recession is about to hit Main Street like a Tsunami and rattle this economy to it’s core.

“Wall Street made a lot of mistakes, regulators made a lot of mistakes, we are going to have to get through that… people on Main Street who think Wall Street is too far away, has no implications for their lives – are just misunformed.” – Bernanke

How could things get worse?  For starters… Since interest rates on a tremendous number of subprime and other ARM are due to adjust upward over the next year, you can expect much bigger payments for people who were fucked to begin with, leading to more delinquencies and foreclosure filings.  Unemployment numbers are hitting new highs every month, those employed are working for less money and real estate values are expected to continue to slide yet down an additional 20%. 

What happens to consumer confidence when Mr and Mrs Smith open their 3rd quarter 401K statements and realize that 20-25% of their retirement just melted away.  I’ll tell you what they won’t be doing… They won’t be running off to circuit city snatching up 62″ plasma’s, planning extravagant European vacations or loading up their calenders with pricey dinner reservations. 

These are dire times and current economic conditions are the most challenging Gen-X has ever seen.  As this recession continues to gain momentum, you should focus on two things… saving money and holding on to your job.  Money is worth less, harder to make and impossible to borrow.  Fasten your seat-belts, get any and all credit/debt issues you have under control and live within your means (below your means if possible).

If there was ever a time to stock up on canned goods, ammo and hide your money in the mattress, this is it.

-Regular Joe

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