The Sub-Prime Chickens Are Coming Home to Roost

Actual Conversation from last week:
Investor, to his stock broker: "Do I have anything in my portfolio with exposure to the sub-prime mortgage market?"
Broker: [laughing]

From the Wall Street Journal, 3/15/07:
"People lack the tools to quantify the exposure of the financial system to subprime, and where there is uncertainty, you sell first." -- Teun Draaisma, co-head of European equity strategy at Morgan Stanley

The Point: Everybody who has anything invested in the stock market is directly or indirectly exposed to the sub-prime mortgage market, and as the sub-prime bubble goes, so will go the market.

Sub-prime mortgages are loans made to borrowers with sketchy or outright bad credit, usually taken out to buy houses or refinance existing loans. These types of loans sometimes have higher-than normal interest rates, but also include loans with certain features that allow borrowers to pay abnormally low interest rates--or no interest at all--for a certain period, in exchange for having to pay a higher interest rate later.

Some mortgage lending companies began rampantly making sub-prime loans in late-2001, early-2002, when the Fed FUnds rate--the Mother of U.S. interest rates--was cut to 1% to spur investment and envigorate the U.S. economy post 9/11, post tech-bubble. Lending companies could borrow money cheaply, and lend it out to risky borrowers at whatever crazy interest rate or payment scheme they wanted, and they tried everything; adjustable rate, option-adjustable rate, negative amortization, you name it. This worked because the borrowers could simply refinance their loans a year or two later, sometimes from the same mortgage companies who gave them the loan in the first place. What did it matter if money was so cheap they could just keep borrowing? The problem is, interest rates have been going up.

The Fed Funds rate is still low by historical standards, at 5.25%, but it has gone up enough to squeeze margin borrowers, and that is exactly what is happening. Borrowers who took out adjustable rate mortgages are now watching thier mortgages re-set into their higher rates, and in a higher interest rate environment, they can't refinance as easily, or at all, and go into default.

Mortgage companies like H&R Block's Option One, and New Century are already feeling the sting from this phenomenon, and have both reported ugly 4Q2006 numbers. H&R Block is trying frantically to sell Option One, and New Century just said its banks have shut off its access to new money.

How this impacts the market is that many banks and financial institutions have exposure to the sub-prime mortgage market, either because they lent money to the mortgage lenders, or they have sub-prime lending operations themselves. If the banks start losing money, they'll start charging more interest. If that happens, investment dries up, people stop spending money, the economy slows down, the stock market drops.

The sub-prime bubble can even have more direct effects on the economy, through the housing market. If the mortgage lenders are losing money, they won't lend as much or as cheaply. So on the margin, people who could previously buy or build new homes won't be able to. That means there will be less new home construction, which means less new orders for lumber, concrete, building materials, even things like washers and driers, refrigerators, etc. Also, if people have to pay more on their re-financed loans, or pay more to take out a loan, they'll have less money to buy things like cars, take vacations, OR invest in the stock market. We live in a debtor society, where people are living beyond their means now more than ever before. When the credit starts to dry up, so does our economy.

This is basically why when people start to hear that sub-prime mortgage companies are in trouble, they start pulling their money out of the stock market. That's why even if you have your money in Marvel Comics stock you'll be affected. Watch your portfolio closely, but if you're still in, you might as well stay in for the long haul. On the other hand, if you actually DO have any money in mortgage lending companies, I would get it out now.

Comments

Anonymous said…
when the wind blows even turkeys fly. when it stops blowing sub-prime mortagees lose thier homes. the wizards who finance such people can afford to lose the money. let them stew in their own in their own juices. the real error is putting people into purchase agreements where they eventually default
DebbieKaye said…
I read all seven of your last blogs. You sure can write! Although I can't understand the financial world it seems to me that the buying practices of today are similar to the types of buying that got us into the depression. Sub-prime and buying on unsecured credit (credit card debt) sounds like margin buying to me...I agree with you, I think we had all better be careful.
Anonymous said…
Good article on sub prime mortgages -- a little bit of education for me
Thanks
UK

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