The Sub-Prime Market Crisis

— Nomi Prins

IT WASN’T UNTIL I flew to the United Kingdom on Saturday, September 15th, that the globalized nature of the sub-prime contagion really hit home, as it were, for me. On my flight over, I grabbed a copy of the UK Telegraph newspaper, the front page of which looked like something shot at a Great Depression bread line.

Following an announcement that the Bank of England would act as its lender of last resort, on September 13th scared customers queued at the doors of Northern Rock, a Scotland-based lender, in larger numbers than to a Harry Potter book release. They sought to extract their hard-earned cash, $4 billion worth, on fears that a credit crunch would drive Northern Rock to ransack their accounts to make up for lack of liquidity.

People who never even heard of a credit crunch were talking about it the next day on every street, bus and tube. The ensuing panic caused the bank’s shares to fall 35% and “BANKING CRISIS” headlines to adorn mainstream United Kingdom newspapers on September 18th.

If the financial markets weren’t so exceedingly globalized, it might have been possible for the impact of the past six years of loose mortgage lending in the United States to remain contained within its borders. Even the sub-prime component that’s been getting all the media attention, and wreaking national havoc as the housing market melts above it, should not have spilled overseas. Indeed, the sub-prime percentage of the overall United States mortgage market, at 15%, is three times larger than it is in other countries, like the United Kingdom. (See this document from the Federal Reserve.)

Yet the financial industry’s gleeful disregard for the potential risks of excessive lending, aggressively marketed to a public told that housing was a safer investment than stocks, created a virus. Incestuous trading of sub-prime and other esoteric mortgage-backed securities amongst the international banking community transmitted this virus. And as soon as substantial fears of a sub-prime-led meltdown in an already deteriorating housing market were unleashed on mainstream television — notably when investment bank Bear Stearn, announced that sub-prime defaults were destroying its credit hedge funds — the virus became a full-blown global epidemic.

The Dow, having flirted just below highs of 14,000, lost over 1000 points between mid July and mid August. International stock markets plunged in solidarity. The media began covering the sub-prime market crisis with a vengeance, and declines in housing prices, construction, related jobs and consumer confidence accelerated.

Back in the UK, following the run on Northern Rock other top banks such as Alliance Leicester plunged 30%, wiping out $2.4 billion of the company’s value. Bradford and Bingley dropped 15.4%. (The Independent, hardcopy cover, September 18, 2007) It only took two months for the average United Kingdom borrower to be impacted by the U.S. sub-prime calamity. Global contagion was consummated.

Cheap and Mad Money

The United States honors two prized exports, war and debt: We lead the world in exporting debt, Treasury or sub-prime. We also treat our purveyors of the banking system differently stateside. As Federal Reserve Chairman Ben Bernanke was being heralded a savior by the financial industry and its media as a late-to-the-table hero for cutting rates to aid market liquidity for the banking system, the governor of the Bank of England, Mervyn King, was being grilled in front of a Treasury select committee for his crisis remedy – promising to back up all of Northern Rock’s depositors, or take on Northern Rock’s bad loan problems.

Stepping back to the end of August, the U.S. business media, in the guise of CNBC’s Mad Money Jim Cramer, begged for rate cuts to help “the average homeowner.” Jim’s words “they know nothing” regarding their previous sidelined position on rates, echoed around the Internet and even made The Colbert Report.

Jim was speaking for the average American, he said — or was he? In reality, those cuts only helped the institutions that had lent money under risky and often predatory practices to begin with. They didn’t then call their distressed borrowers and pass on their new-found liquidity, or  subsequently lower their rates commensurate with the Fed cuts.

In the UK the media skewered King, and the Treasury select committee (equivalent to our Senate Finance Committee) grilled Deputy Bank of England Governor, Sir John Gieve, calling him “asleep at the wheel” for ignoring signs that Northern Rock had detailed problem loans in their July interim result report. Meanwhile, the Fed cut spurred a Wall Street surge last seen in magnitude in 2003 (helping borrowers not at all). The Dow Jones rallied 335 points, or 2.5%.

There can be no doubt whom that additional liquidity helps, nor whether banks are really as stretched as they whine; consider the sign that hung at a Sovereign Bank window on Park and 20th street a week later: “Red Tag Home Equity Sale, .76% interest.” Yes, that’s right, instead of 7.45%, Sovereign in late September was giving money away. In your face credit crunch! — they were saying to prospective customers, this on their supposedly “squeezed” liquidity.

Banks always find a way to get liquidity. It’s just periodically more difficult, as when Bear Stearns’ credit funds plunged and oozed poor returns all over their investors, who publicly headed for the hills. But this time, as in the past, the Fed stepped in. That is their job, the Fed would say, to provide liquidity to the banking system. But, even so, they stop short of reprimanding banks for the practices that led to their own liquidity problems (preying on customers) or suggesting they share the spoils with those customers by resetting their loans.

Rescuing Banks, Not Borrowers

Before forecasting whether the sub-prime crisis will end anytime soon, let’s examine the numbers. The U.S. mortgage market, approximately $11 trillion in size, encompasses about $1.5 trillion, or 15% sub-prime loans. (See This document from the Federal Reserve.) Cheap money caused those loans to balloon as a percentage, particularly over the last two years; even as housing prices stagnated. In 2006, $600 billion new sub-prime loans were originated, compared to $120 billion in 2001, or only 6.5% of the market.

But the general lending problem, although it’s dubbed the sub-prime problem, is not exclusively about those sub-prime loans, though the lending practice of sticking less credit-worthy (i.e. less economically, ethnically or racially advantaged) people with higher interest rates is certainly a contributor to the housing market downturn. Banks strategically chose to prey on the least able, charging them the most on a monthly basis, bombarding them with ads, phone campaigns, and the means to borrow beyond their means.

Who couldn’t see that train wreck coming? People with less money and stability having to pay comparatively more? Yeah, that was sustainable.

When the inevitable happened and borrowers couldn’t make their payments, banks and lending institutions got scared. All their free-market capitalist tendencies to avoid, say, regulation of those types of loans instantly converted to tremendous support for a government bailout via the Federal Reserve — which had previously ignored the housing lending bubble and any discussion of reining in lending practices.

Until mid-August, Ben Bernanke was concerned about inflation. And there has been cost inflation in gas prices, health care costs, tuition and prescription drugs — there still is. That makes the effects of the housing decline worse — real people have to face inflationary increases in basic needs and services, plus drops in home values.

There have been other casualties; the nation’s largest lender, Countrywide, announced layoffs of 3500 by the end of the year. Several Wall Street firms are bleeding out sub-prime employees. More than 150 mortgage lenders have closed their doors due to bankruptcy or unsustainable liquidity problems and lack of appropriate reserves. (See coverage from CNN.)

Who’s to Blame?

When there is catastrophe, there is blame. Some lenders, like Countrywide, blame the economy — a recession is causing housing prices to drop, not the impossible loans fashioned to maximally extract from the least able borrowers, nor exaggerated appraisals to increase mortgage balances. Developers could be blamed for dumping supply onto an already saturated market. The media could be blamed for perpetuating the post-dot.com and Enron myth that your home can never decline like the stock market can. And yes, even borrowers could be blamed for not being more responsible; they shouldn’t have bought what they couldn’t afford.

According to the November 2006 Demos “House of Card” report, Americans tapped into their home equity in record volume during the past five years; they cashed in $1.1 trillion (roughly 10% of the mortgage market) in home equity loans since 2001. Thus Americans have less equity in their homes then in the 1970s or early ‘80s.

This borrowing frenzy exacerbated the looming crunch for the average American. People paid off credit cards with their homes — thereby swapping five-year debt (albeit at stupidly high interest rates) with longer-term, 30-year debt using their homes as collateral. Their credit cards were used to pay for the basic needs in many cases, but with the thought that rising home equity would remain available to offset them.

The cheap money that banks were offered in 2001 and 2002, enabled by former Fed chairman Alan help-the-banks Greenspan, created advantages and disadvantages — for banks. The advantage was that banks had more to lend, the disadvantage was that they they made less margin –- which is why they had to think of ways to increase volume to compensate.

The banks cast a wider net for profits. They lured in more sub-prime borrowers; decreased requirements for down payments as a percentage of overall loan size for all borrowers; and took advantage of the psychological attractiveness of low rates by pushing adjustable-rate mortgages (ARMs) which start with lower, than reset to higher rates, and interest-only mortgages (IOs) which start with smaller interest payments and subsequently reset to higher payments including interest and principal later.

Banks assumed further that in the event of foreclosure, the rising market would provide a perfect environment for profiting from reselling any foreclosed property. This was the same argument used by hedge funds to pursue institutional investors’ money to purchase packaged bunches of sub-prime loans.

The only problem: Exuberant development led to a glut of supply. With that, coupled with resetting loans accompanied by higher monthly payments causing individual cash crunches, the housing market stopped rising, and the idea of selling a default property into a saturated market lost appeal.

Then the loan chickens came home to roost. According to the Demos Report, approximately, $1.4 trillion ARMs reset in 2006 and 2007 ($400 billion in 2006 or 5% of outstanding debt, and $1 trillion in 2007 or 12 %.) On average, affected borrowers will shell out 25% more on monthly payments. Additionally, 20% of the mortgage market since 2005 is comprised of IOs, yet to reset to include principal pay downs.

The other nail in the housing problem coffin is the home appraisal. Appraisal fraud (consisting of appraising homes at higher values than their market worth, to enable lenders to lend, and thus reap interest payments back from, bigger balances) increased seven fold since 1999. (See Demos Report.)

Finally, lack of liquidity in the market is a self-fulfilling prophesy. If people don’t have real equity in their homes, they can’t borrow more against it, meaning they won’t spend that extra money on their homes, or the general economy. This will cause contractions in consumer spending, and consumer confidence (at a four-year low).

People will move less, causing relocation companies strife. They will improve homes less, causing companies like Home Depot anguish. Construction will continue to decline, one of the reasons that mega-developer Lennar is cutting 35% of its workforce. Repercussions will keep reverberating through the real economy.

Silver Linings?

For the real people facing foreclosure, clawing back will be painful. Unfortunately, there’s no magic wand that will remove the oncoming pain, but there are ways to reduce its force and create a safer lending environment for the future. For instance, bankruptcy laws should enable people to protect their homes in the event of having to declare bankruptcy.

Congress should address appraisal fraud. They should also enact measures to protect borrowers from excessive rate increases, fees and unforeseen charges. At the end of the day, this will also protect banks and lenders from delinquency and default volatility that hurts their liquidity and profit margins, but will have the more important added benefit of helping the general home-owning population.

For those who never got into the real estate game, the news is slightly brighter on one accord — rent. Rents in the United States will decline. All those developers who promised speculators great deals that they could transform into rental income are sitting on excess inventory. If one can’t sell property, they can rent it. But if a lot of property doesn’t sell, then there’s a lot more rental inventory for renters to chose from, this makes finding rental property an easier prospect, at cheaper levels.

The other good news for homeowners is that the foreclosure process takes time, five to 18 months. Banks really don’t want to take possession of a plethora of unsellable properties (if they were sellable, borrowers could have sold them and rented instead). This means that homeowners facing increased rates or unpayable debt have more negotiation power than the media or lenders would have them think. The problem could be contained for the homeowner as well, since the market will contain supply.

Americans can also take some solace from Wall Street activity, even as housing prices have not yet bottomed out. Three months after Bear Stearns’ stock price tanked amidst sub-prime issues, billionaire Warren Buffet is rumored to be making a bid for 20% of the firm. He is obviously less concerned about continued downside to that portfolio, or the firm, not least because of interest rate cut gifts from the Fed and the general resilience and ingenuity of Wall Street.

from ATC 131 (November/December 2007)