Saturday, March 31, 2007

Why You Should Care About Subprime Loans

You've read a lot about the sub-prime mortgage market lately and how people from Ben Bernanke to the average shmoe with a few bucks stashed away in his 401(k) are worried, but all you've heard is a lot of reassuring talk amidst the smoke from a distant fire.

There's a reason the Fed chairman has had to reassure the public, twice now: he's protecting his cronies:
In good times, unsustainable loans still turned a profit; the lenders reaped short-term fees and quickly sold the loans to investment banks which chopped them up, repackaged them, and flipped the debt to hedge funds and institutional investors. Now the gravy-train is derailing, and as CFR’s Sebastian Mallaby argues in the Washington Post the investment banks could be exposed as the real scoundrels of the subprime blowup. The banking giants “bamboozled ratings agencies into assigning misleadingly high credit scores to some mortgage-backed bonds,” Mallaby says. This enabled them to pawn off bad debt, disguised as good debt, to unwitting investors.

How far will the damage extend? Bloomberg, in the article cited above, says subprime housing-loan woes could spill over into the auto-loan industry, where highly speculative loans are also prevalent. The issue has global ramifications as well: In late February, subprime concerns sent stock markets tumbling on fears of a U.S. economic slowdown. Even though subprime loans aren’t nearly as common internationally as they are in America, a U.S. credit crunch could still suck liquidity out of global financial markets. Testifying before Congress on March 28, the U.S. Federal Reserve Chairman Ben Bernanke said the subprime issue thus far has had only minimal effects on the broader U.S. economy. But some factors remain unknown. Perhaps the most frightening question is what happened to all that bad debt the investment banks pawned off. Hedge funds, the Financial Times’ Gillian Tett points out, are often masters at using tricky paperwork to cover up their losses. But somewhere, somebody is taking a heavy hit right now. Tett wonders: “Where are the bodies buried?”
The bodies, indeed.

As always in American history, there are parallels to be compared. In this instance, in our own lifetime, we have just such a parallel: the 1989 junk bond bust. Created by the Reagan administration tax cuts, which accelerated depreciation on assets purchased, and exacerbated by President Jimmy Carter's relaxation of regulations on the banking industry (Regulation Q), junk bonds became ubiquitous in the 1980s, through the efforts of investment bankers like Michael Milken, as a financing mechanism in mergers and acquisitions. In a leveraged buyout (LBO) an acquirer would issue junk bonds to help pay for an acquisition and then use the target's cash flow to help pay the debt over time. Basically, it became cost effective to borrow large sums of money at high interest, purchase the stock of a company, take it private, gut it, and all the while, make money (on a tax and cash basis) for the investors.

While screwing everyone else. Eventually this house of cards had to crumble.

Likewise with the sub-prime debacle, as the CFR article notes, enormous sums of money were made in a grand game of hot potato, where the loser is the one holding all the default mortgages at the end.

Namely, the US taxpayer. Remember, Republicans like to privatize profit while socializing losses. We will end up paying for this, just like we ended up paying for the savings and loan crisis (which was an ancillary impact of the junk bond market collapse). A good blogger would point out that a certain former Senator from Tenessee and former TV star with presidential aspirations worked as a lobbyist for the S&L industry. Didn't you, Senator Thompson?

That one was cheap: only $106 billion

There is $7 trillion in mortgages out there. Most of that is safe. But if even $1 trillion (not an unlikely number, since this crisis now spans some six years of mortgage lending before anyone took note and the annual mortgage market in the US is north of a trillion dollars a year, including refinancings and second mortgages), if even $1 trillion is at risk, that could create an economic collapse that would make the Great Depression look like a day at the beach.