Highway to hell

The sub-prime meltdown is upon us. What does this all mean? I have a couple ideas that are not necessarily connected nor quantified. I would think quantification, at least, is left as an exercise.

So, what do we know? Lets make a list:

Sub-prime mortgages are housing loans made to people who would normally not qualify for a home loan.

at the time these loans were made the housing market was rising
interest rates were going up slightly (Fed was raising the interbank loan rate to 4.25%)
houses were being built on "spec" - builders built houses anticipating (speculatively) that a buyere would appear to take the house off their hands
realators were encouraging buying in a "can't loose" scenario in which the house will be worth more in a few minutes than it is now (free money) (keep in mind that relators make 3-6% on the sale of a home so they are interested in some of the free money too - that is to say that they have their own self interest at heart - they cannot ever be viewed as objective)
bankers were winking at loan applications and not checking references well (keep in mind that the banks get paid for processing loans so they benefitted from closing a loan so they abaondoned the objective roll they traditionally hold in proteting the bank's money - after all, if the borrower should default (and few did) the property would be worth more than the mortgage so the bank could'nt loose either)
the banks repackaged the mortgages and sold them as mortgage backed securities(MBS). So the banks got their capital back right away with some of the yeild on the mortgage while the MBS buyers coughed up the cash in exchange for the remainder of the yield for the life of the mortgages. So the banks gave up the responsibility for knowing if the morgages were good long term investmets or not
The rating corporations, which rated the MBSs, did not perform due dilligence in determining if the packages of mortgages were investment grade or not. This was partially because many sub-prime mortgages came with mortgage insurance. So the ratings were over blown. Mortgage insurance comes in two colors: government secured loans and commercially insured loans. Veterans, for instance, have their mortgages garunteed by the federal government. This reduces the risk in loaning to a vet because the government stands behind the loan. That means the interest rate to the vet can be lower. For other non-vets, a loan may be beyond reach without mortgage insurance. So some of the sub-prime mortgages had insurance and some did not.
The mortgage insurers are smart people - they look at the statistics and can readily estimate the risk at any given time of mortgages (collectively) defaulting. So all they need to do is to keep enough liquidiy on hand to meet the statistically based contingent liablility of their worse canse senario (is this mean plus 1, 2 or 3 sigma?). In practice, that never happens so compared to the sum of the values of the mortgages they insure the amount of cash they need to hold is small. The other little thing is that they only need to provide the difference to the mortgage creditor between the value of the mortgage and the sale price of the property at liquidatiaon. In a rising market their exposure keeps going down. But where does the cash on hand come from? It comes from the insurance premiums the buyer pays in his monthly mortgage payment. Once the cash on hand meets the level needed to meet the contingent liablity what do you do with the rest of the premiums? You invest it, of course. And what did the insurance companies invest in? Yes, thats right, Mortgage Backed Securities.
As the number of qualified home byers who did not have a home goes down, the number of real estate transactions goes down. The bankers and home loan companies start marketing to the sub prime market. They create innovative ways to "help" home buyers get into a home. In doing so they essentially create a new untapped market of sub-prime buyers. This market is fueled by mortgages that feature zero dollars down, interest only variable rate loans. The theory being that in a rising market the equity in a house builds rapidly. So you can get a zero dollar down, interest only variable rate mortgage and, by the time the ARM i s ready to adjust, you will have sufficient equity in the house that you can re-finance the loan using the equity in the house as a down payment. Then what you get is a fixed rate loan on the now reduced principle and, because you have a substantial down payment in the form the the equity you have built, you qualify for a lower interest rate loan! Who could resist such a deal?

The "wealth effect"

We should not ignore this as its part of the bigger picuture
Alan Greenspan mentioned the "wealth effect" back in the 1999-2001 time frame to describe the effect on the economy that the rising stock market was having. That was during the dot-com bubble, or boom (take your pick). Every dollar that went into the tech sector of the market made money. People were in tall cotten. ( I had like a million dollars in stock options from MCI). Stock options were also abundant. People were spending money based on their worth on paper. They collateralized their holdings to get loans and buy things. ( I should add here that we bought a van by selling a fraction of our holdings in MCI on the weekend the stock's high watermark. In retrospect I should have sold it all also bought the Porche 928 that I was looking at. I would have, in the end been no worse off and I would have had a big grin on my face).
Everyone who bought a house experienced, at least for a while, a gain in the value of the house. Thats called equity. You can sell the house for more than you paid for it and more than the balance due on your mortgage. Its a money making deal. As a general rule of thumb its hard to make more money than you can spend. In fact, its hard to make as much money as you do spend. This last observation seems to be part of human nature and there are lots of people out there who are paid to help you achieve that end. Amoung them are they who would help you liquidate all that new found home equity so that can buy more of the things others are trying to sell you. And that's what happend. These are called home equity loans. You cash out your equity as a 2nd mortgage or a refinance of you home. The net effect is that you borrow out the equity and spend it in return for a modest increase in home mortgage payment. Remember that the interst rates are low so geting money is cheap and you can pay the money back over time. Any way - you home is increasing in value so you can do this trick several times! Its a money makeing deal - a never ending ATM machine!
People refincanced their homes in droves due to the low interest rates. They bought bigger homes too. Their buying drove up the cost of homes which increased their equity which increased the wealth effect. Which drove up the GDP. Which drove up the negatve balance of trade.

The price of houses stopped going up

Well, actually, thats not the first thing that happend. Interest rates went up a little. Not much - just a little. And that meant that it was harder to buy a home. So a few less homes were sold. So the price of homes did not go up as fast. And ARMS began to reset from the zero interest rate to the higher rate. So payments went up. And people began to default on thier homes. So houses got repossessed. And the market , which was cranking out houses as fast as they could be built, began to accumulate a backlog of unsold houses. And this cycle repeated and repeated as the backlog of unsold houses grew and grew. So the price of houses began to fall. And that was important.
When the market is growing it is consuming ever increasing amounts of material and labor and money. As market stagnate, backlogs of unsold materials build up, houses, housing materials, furnature, toiltes, sewere pipe all waiting to be sold. But there are no buyers. So wharehouses become full of unsold goods. So factories stop producing product. And they lay off unneeded workers and stop buying the raw materials. All down the supply chain workers are layed off and materials fill the wharehouses. The layed off workers stop buying all the convieniences they had been as they pare down their budgets to survive. All the little extras go. So all the people who make the little extras find that they too aren't needed to make the little extras and everyone stands in the unemployement lines.
Remember the wealth effect? The folks who had all those re-fis and 2nd mortgages suddenly find that thier homes are selling for less than they owe on them. They also realize that they have no equity in the home so they can't cash out any more. And that means that althought they have been living "beyond their means" here to fore, they cannot get any more money out of their home. So they either have to trim their spending or begin adding to their credit card debt. And thats what's happening. But they are stilll spending more than they are making. Its good for the ecoonmy, you know.
When people get in the crunch and are at the end of thier credit, what are they doing? They are ditching their homes and the mortgage that goes with it. Remember, they are "upside down" in those mortgages. They owe more than the house is worth. With any luck that puts them in an apartment or rented house that frees up some money to pay the bills with. Maybe. The question is "who pays the difference between what the house sells for and the amount owed on the house"? That takes us back to insured loans. The insurance takes care of it. Providing, of course, the insurance company has the where with all to meet the payment demand.
The insurance companies have to make payments that are way outside their predicted rates of defaults. They are invested heavily in MBS and have to sell them off to get the funds to meet the demand payments. But the MBS are now of questionalbe value. Some payments to mortgage holders are made in mortgages held in the MBSs - not cash. The finance system no longer knows what the value of its assets are. Everybody begins to write down the value of their assets. So their net worth goes down. And thier ability to pay goes down. When the music stops someone will be left without a chair.

houses are assests

true, they may not be worth much, but they can be carried on the books till they are sold, whatever the value.
the population is growing and have to be housed
the houses will be sold but not at today's prices
prices can't really rise till there is competition and demand for the product
at the right price with qualified buyers, houses will move
realators will make money
banks will make money
things will look better

I just wanted to stop here for a second and let that last section soak in for awhile. I was thinking about this in the shower the other morning. What I was thinking is that during the downturn banks are writing off mortgage losses left and right. So their stocks are dropping like proverbial rocks. But wait - what would a smartish banker do? After all - he still has the houses and he's written down the loss. If he could move those houses at say 60% of the value of the mortgages - that would be pure profit. His balance sheet would look better going forward and he'd look like a hero. Now - who to sell the houses to? Well, it seems to me that he had identified a whole new market segment to sell houses to with the zero down no interest ARMS. That market is still there - they just were tossed out of their expensive houses. But what we notice is that they were able (albeit maybe barely) to make the payments on their zero down interest only mortgage. With lower interest rates and houses devaluted 40-60% how many of those buyers could afford to purchase one of these homes? All of them? So my thinking leads to buying bank stocks at the bottom or as close as you can get because the house devaluation is going to open up the subprime market as a prime market on the way up. Just a thought....

banks will not get burned twice

at least not in this century
this happend in 1929
we put laws in place to limit what the greedy could do
that will happen again
rules for making loans will tighten up
qualifiying for a loan will become harder
it will take longer to work off the backlog of exisitng homes
home building, except for the rich, will rebound slowly
lower interest rates will help because

the ARM resets will not be as severe thus damping to some extendt the rate of defaults
qualified buyers will be more qualified
qualified home owners will refinance to a lower rate (maybe even cashing out remaining equity)
there will be a combination of good deals on house pricing combined with good interest rates for the qualified

inflation

against this background the Federal Government is borrowing $3B per day or $90B per month
by lowering interest rates we make more money avaiable - money is created by the makeing of loans at the rate of 10 times the value of the loan based on the observation that banks have to maintain reserves equal to 10% of their deposits ( they can loan out $90 of every $100 deposited) (its a progression)
low rates stimulate loans which increases the money supply
increasing the money supply cheapens the dollar
folk who buy U.S. Treasuries want a reasonable return and so want a rate that compensates for the cheapening of the dollar. So either the interest rates go up on the treasureies or the price of the bond goes down (increasing the yeild which effectively increases the rate).
As tresaruey rates go up bank rates go up (its competition)
As bank rates go up houses get more expensive to own.
So does every thing else.
So employment goes down.
keep in mind here that in the near term, as employment goes down, tax revenue at all levels of government goes down so government borrowing will go up or, where balanced budgets are mandated, services will go down or taxes will go up
reducing services means laying off public servents
rasinig taxes will reduce disposable income

Just at the moment

We have one factor boosting the economy - lower interbank rates
We have several factors (one latent) depressing the economy:

depressed housing market
reduced consumer spending ( home ATMs no longer work )
federal borrowing driving up inflation
lower tax revenues

Future state

reduced consumer spending means that the consumer economy will contract and only grow with the population thereafter
so the econoy is going to contract some percentage and I suspect will oscillate up and down untill it re-normalizes in the new economic reality
I suspect we will see some negative economic impact on this evolving economic revolution as the baby boomers step out of the work place. While I anticipate that fewere of them can afford to retire than want to retire that remains to be seen. There are essentially no workes to take their places when they retire. At 4-5% unemployment, there is nobody left to step up as they step down.