Subprime Meltdown Has About Run its Course

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Tuesday, October 9, 2007 started as a nice day in New York City. A lovely early fall day, with the temperature still a balmy 80° at 2:00 in the morning. By evening, though, the temperature had dropped twenty degrees, the clouds had rolled in, there was thunder and rain.

As with the weather, there were some hints of trouble here and there on Wall Street. But all in all, things could not have seemed better. Little did we know, the stormy end of 10/9/07 signaled a very large bubble that had just popped.

That was the day when the Dow Jones Industrial Average hit its historic peak. From there, it was all downhill – slowly but steadily at first, and then violently after last August – until the Dow bottomed (for now) on March 9 of this year. Over that span, the index lost 54% of its value.

It’s been a crushing blow to just about everyone. But it’s already being referred to as the crash. As if the unpleasantness were now all behind us. More likely, in the future it will be seen as, simply, the first crash.

Don’t believe it? In a moment you will, when you see the scariest graph of the year.

But let’s quickly recall what’s already happened. During the late, great housing boom, interest rates were at microscopic levels, while bankers were encouraged to grant home loans on little more than a wink and a nudge. In order to inflate their balance sheets, those bankers resorted to all sorts of gimmicky, adjustable rate mortgages (ARMs), whose common feature was an interest rate that would eventually reset. That is, it would balloon somewhere down the road. And those most likely to come quickly to grief were the riskiest borrowers, who held loans known as “subprime.”

“But not to worry,” borrowers were told. “Betting on ever-rising home prices is the safest wager in the whole wide world. If you have problems with cash flow when the ARM resets, your house will be worth a lot more, so you can simply sell it and walk away with a nice chunk of change in your pocket.” Uh-huh.

The bankers themselves were a little more concerned about the deterioration of their portfolios. They took out insurance in the form of credit default swaps (CDSs). These were a brand-new invention in world financial history, allowing mortgages to be sold and resold until they were leveraged 20 times over. They became the shakiest part of a huge global derivatives market, with a nominal value in the tens of trillions of dollars.

For a while, this Ponzi scheme even worked. But then, as they had to, the ARMs began resetting, and there were defaults. Then more of them. Because at the same time, the housing market was cooling off and the economy was stalling out. More and more people were trapped in a situation where they owed more on their home than they could sell it for. Many simply mailed their keys to the bank and moved on.

All of this wreaked havoc in the derivatives market. Sellers of these exotic packages could no longer establish what they were worth. Buyers couldn’t determine a fair price and so stopped buying. As the ripples spread through the world financial system, trust disappeared and liquidity dried up.

Now consider that the base cause for all that dislocation was the subprime sector. And how big is that? Not very. Subprime mortgages account for only about 15% of all home loans. Their influence has been way out of proportion to their numbers, because of derivatives. Here’s the good news: the subprime meltdown has about run its course. These loans were resetting en masse in 2007 and the first eight months of ’08. Now they’re pretty much done.

And the bad news? No one in the mainstream media seems to be asking what should be a pretty obvious question: What about loans other than subprime? Truth is, the banks didn’t just trick up their subprime loans. ARMs were the order of the day – across the board.

Now, here’s that frightening graph we referred to earlier.

Take a good, long look. You can see that from the beginning of 2007 through September of 2008, subprime loans (the gray bars above) were resetting like crazy. Those are the ones people were walking away from, sending a shockwave from defaults and foreclosures smack into the middle of the economy. Now they’re gone.

The ARM market got very quiet between December 2008 and March 2009, hitting a low that won’t be seen again until November of 2011. Small wonder a few “green shoots” have poked their heads above ground. But in April, resets began to increase and will reach an intermediate peak in June. After that, they tail off a little, going basically flat for the next ten months.

It’s not until May of 2010 that the next wave really hits. From there to October of 2011, the resets will be coming fast and furious. That’s 18 months of further turmoil in the housing market, and the beginning is still nearly a year away! (Although the months in between are likely to be no picnic, either.)

While it isn’t subprime ARMs that are resetting this time, neither are they prime loans. Those eligible for prime loans wisely tended to stay away from ARMs in the first place, as indicated by the relatively small space they take up on each bar.

No, the next to go are Alt-A’s (the white bars), Option ARMs (green) and Unsecuritized ARMs (blue). Alt-A’s are loans to the folks who are a small step up from subprime. Unsecuritized loans are a 50-50 proposition; either the borrowers were good enough that they weren’t thrown into the CDS pool, or they were so risky no one would insure them.

Those two are bad enough. But Option ARMs are the real black sheep, loans with choices on how large a payment the borrower will make. The options include interest-only or, worse, a minimum payment that is less than interest-only, leading to “negative amortization”-a loan balance that continually gets bigger, not smaller. Imagine what happens with those when the piper calls.

Once the carnage begins, will it be as bad as the subprime crisis? That’s the $64K question. Perhaps not. For one thing, subprime loans were a much larger chunk of the market when they started going south. For another, there’s been a lot of refinancing as interest rates dropped; that should help ease the default rate. And the government has massively intervened, with measures designed to prop up those who would otherwise lose their homes.

On the other hand, we’re in a severe recession, which wasn’t the case when the subprime crisis started. More people will be unable to meet payments. And the housing market has continued to decline, pressuring both marginal homeowners and banks that can’t sell foreclosed properties.

Is the stock market’s next 10/9/07 on the way? Yes. Which day will it be? That’s unknowable. It could be in a week, or not for another year.

But make no mistake about it, the second crash is coming. It can’t be prevented, no matter what desperate measures Obama and his hapless financial advisors come up with. All we can hope for is that, with a little luck, it won’t be as severe as the first one. But it will last longer. We aren’t even in the middle of the woods yet, much less on the way out.

Regards,

Doug Hornig
for The Daily Reckoning Australia

Doug Hornig
Doug Hornig is a senior editor for Casey Research, publishers of Doug Casey's International Speculator... for over 27 years providing investors with unbiased and carefully researched recommendations for high-quality gold and other natural resource stocks with the very real opportunity for a 100% or better gain within a 12-month horizon. Hornig also writes the Daily Resource, a daily column that appears on the KitcoCasey and Casey Research web sites.
Doug Hornig

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Comments

  1. Doug, the graph says it all as you show. I’ve been reading this information for several months now here and there but never so succinctly.

    Reply
  2. I’m not suggesting for a minute that I have faith in financial institutions and regulators, but theoretically if these banks have been stress tested, it would have included this information. The banks with a dire reset schedule have been told to build up reserves for that and now they’re at various stages of doing so. Some better, some worse.

    So defaults might go up but banks have better reserves to refinance these loans rather than write them off. So some people might end up mortgaged until they’re 100 and that’s their own fault, but for those of us that stayed out of that party, it’s OK? No?

    Reply
  3. Who in their right mind would refinance for 100 years, Jeremy? I mean ALL my loans are for a max of thirty years and frankly, I doubt I have 28 left. Years, not loans. Hey, it’s a great party! We are all going to pass on… lighten up… . It’s my kids’ kids problem. “You’ve got to… spend a little… bend a little…” Wanders off… feeling no pain… . “I’ll have a bottom of wine, please… Mz Dentist Lady.”

    Biker Pete
    June 5, 2009
    Reply
  4. Against this backdrop of bad news, we need to also keep in mind that housing affordability have been rising, soon it will be at historical height, so the basic demand and supply says there will be lots of supplies but at the same time demand will pick up too, and things will not falter too badly the second time around.

    Reply
  5. Jeremy, even if banks did take this information into account during their stress tests, does that mean a whole new bunch of Americans won’t end up living out of their cars or in tent cities? I wonder if the economy fall out is going to be avoided – and if so, how is this to be achieved?

    Reply
  6. If unemployment levels were stabilised in the US and were not still rising,the coming impact of next wave housing loan and resetting issues etc might not be too severe..but…unfortunately they are still rising. I think the stress tests had perceived “green shoots” imput factored in as well as crossed fingers.

    Reply
  7. There is a widely held misconception about re-financing mortgages as if it solves plenty of problems. It might for those that do, but there is a counter party to that risk who either accepts that rate risk themselves or passes it onto someone else.Thats the balance of the market.

    Sure it might get diluted, booked away in profits or in deferred losses, fudged away somehow as the accounting rules change, but ultimately for a while some institution earns less interest for a risk that should demand more and eventually the cost comes to the fore, as it did with sub-prime.

    Easy money made it easy to run from the market but there are fewer places left to hide and by the end of next year there will almost be none for the fools and the rip-off artists!

    Reply
  8. Would anyone like to offer their opinion as to why this subject is not widely reported in the mainstream media? On the tail end of the subprime problem one would think there would be much more interest in this. Is it psssible that we (Australians) have developed a false sense of security, considering we came out of the GFC relatively unscathed?

    Reply

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