Tuesday, June 03, 2008

Musings on the Subprime Crisis and Other Economic Stuff 

My dad asked me to comment on the subprime lending crisis, and so I did. After doing so, I figured, "what the heck--I should put this on my blog, and so I did. I invite any reader to correct and educate me with regard to errors that I'm sure are in there.

On finance and economics, I'm no expert, and probably have some facts wrong, but here goes:

The word I'm hearing and reading is that the subprime financial crisis is pretty much over, although there's still cleanup to do in the aftermath. I haven't noticed any impact in our neighborhood, except that the homes that happen to be for sale (one on our street, zero to two each on neighboring streets--not an unusual number, historically) are staying on the market a lot longer than in the past and are going for maybe 10% to 15% lower than the peak price. If we were to sell, that would put our house in the $800k-$850k range. I suspect newer neighborhoods and developments like Bressi Ranch and La Costa Greens may be impacted more because they are newer and the developers sold for much higher prices than we originally paid, with much looser credit requirements imposed by lenders.

As I understand it, the whole debacle was enabled by a combination of loose money policy and greed (surprise! surprise!). The Fed essentially created money by keeping its rates low over many years (since 2002), and that money had to go somewhere. People started to buy real estate not so much as a place to live as a vehicle for investment, and they wanted to make a killing so when they sold, they asked for (and got) significantly more money than they'd paid.. (One of Pat's co-workers and her husband went up that ladder, but they are now stuck with a very expensive house and high mortgage and tax payments, with nobody to sell to.) Developers saw the demand and charged what the traffic would bear, but in the end they overbuilt, adding to supply even as demand fell off. Lenders loosened their credit and down payment requirements for home buyers and refinancers, failing to verify income and lending 100% to value, figuring that they would have enough equity cushion because the prices would continue to rise, or at worst level off. Then those lenders sold the loans to financial firms who bundled and "securitized" them and sold the payment streams to institutional investors like your Japanese banks and other financial companies not just in Japan and the US, but all around the world. All this eventually turned into a "bubble" (or near-bubble).

The bubble burst when the prices got high enough to cause demand to slack off. Some people, especially speculators, who had bought (or refinanced) with nothing down (or took all the equity out of their homes), couldn't find a "greater fool" to sell to, and/or for one reason or another couldn't or wouldn't pay their mortgages, so they defaulted and the homes went into foreclosure. The crisis arose because the investors in the market for those mortgage-backed securities no longer knew how much the mortgages backing the securities (hence the securities themselves) were worth, and nobody was sure who was legally going to have to bear the losses (as between the "bundlers" and the institutions who bought the securities). No holders of the securities could sell or borrow against them because no prospective buyer or lender knew what they were worth, either, and the market in them collapsed, This led to a major liquidity crisis, which in turn caused runs on several investment banks who had large holdings of those mortgage-backed securities, perhaps most famously Bear Stearns.

The Fed originally tried to fix the liquidity problem by pumping even more money into the economy (which has contributed in a major way to the rise in the dollar price of oil and gold) but didn't really get a handle on it until the Fed told banks they'd accept mortgage-backed securities as collateral. Somewhere around that time a consensus formed that the worst-case scenario would be a 30% decrease in value of the mortgage-backed securities, and the market for those securities re-formed. Now the holders of the securities are "marking to market" and reporting losses in their financial statements, but the real "subprime" crisis is over.

IMHO the current problem is the devaluation of the dollar caused by the excess money supply, combined with the true demand pressure for energy resulting from the developing economies of China and India, which together account for almost 40% of the world population. Our politicians aren't making it any better, either, because they want lower energy prices, but won't allow drilling in ANWR or off the California or Florida coasts, won't allow development of oil shale in Wyoming and Colorado, and won't do anything to make it easier to site, construct and operate any new refineries or coal-fired or nuclear electric generation facilities. Nor will they get rid of the import duty on ethanol from Brazil and elsewhere.

What's happened in the retail real estate market (especially the formerly red-hot markets like California, Florida, Las Vegas and a few other places) is that the mortgage lenders have tightened up their credit and down payment requirements to historical levels. As a result fewer people qualify for mortgages and the demand for houses has slackened. Developers with inventory have reduced their prices, and sellers of existing homes have done the same. Eventually prices will get low enough (maybe already have) to clear the market of the surplus supply and prices will stabilize, but it will take time and we won't know it until we look back and see what's happened.

Ironically, the fundamentals have always been strong. According to Neil Cavuto (Fox News Channel business guru) only 4% of all US mortgages are in arrears, much less in default. I've heard and read other authorities say that in much of the US (especially the heartland) neither foreclosures nor prices have changed much in the last year. FDR was apparently right when he famously said, "The only thing we have to fear is, fear itself."

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