Subprime Meltdown

The most important Socrates quote worth remembering may be “the more I know, the more I know I don’t know.” In the spirit of this sage advice, I proudly admit my ignorance when it comes to interest rates, credit management and derivatives, and debt securities. I want to know. It’s all very fascinating. I’ve found the recent “credit crunch” news to be especially interesting.

An interesting byproduct of the subprime meltdown / “credit crunch” is that, once again, we see just how interconnected the financial markets are. We see how increased credit availability popularized HGTV and home flippers (my parents) who increased the price of homes, which makes home ownership impossible for anyone except prior home owners (see previous post), which caused home prices to drop, which impacted subprime borrowers and their reverse amortization mortgages, which impacted credit availability, which impacted buyout firms (who else would buy Chrysler) and hedge funds, which is impacting your 401(k) (especially if you’re a teacher or firefighter), which is contributing to lower sovereign debt ratings of Romania and Argentina, which will impact a simple Transylvanian peasant trying to make a living raising chickens, which will cause the price of poultry to increase, which may contribute to world hunger, suffering, World War III, and the end of this common age. Pretty fascinating!

Financial markets and investment product complexity reached new heights during the 1990s boom years. As the market began to cool and plummet following the tech bubble burst, investment managers took their money elsewhere. Since every segment of the economy was suffering, managers began to invent new ways of seeking alpha. If managers couldn’t rely on tried and true methods of earning returns on their investments, maybe they could print their own money. Enter the arcane world of financial derivatives, credit, securitization, and the ills we find ourselves in today. Suddenly debt became a much more interesting possibility as post pet.com level equity returns leveled off.

Debt could be a way to keep growth alive. But where to start with debt? Real estate! Real estate is tangible – so much more tangible than a dot-com with fictional cash flow. People need a home. Shelter is a basic need. It’s inelastic. People will fork over anything for a place to sleep. But the demand for a $100,000 home is limited by the number of qualified borrowers. The private sector, realizing that growth is everything, asked a pivotal question: “how can we increase demand?” Answer: increase the number of borrowers. Take away those unpatriotic barriers to home ownership. Credit problems? Bankrupt? No job? No documents? No problem.

But the banks and mortgage lenders themselves knew it was a problem. They didn’t want to take on these risky loans. Wall Street was one step ahead of them. Securitization: pooling assets together (like home loans), putting a bow on it, and selling it to someone else. This type of security would be dubbed a Collateralized Debt Obligation (the home is the ‘collateral’). CDOs would allow banks and mortgage companies to unload their risky loans onto Wall Street, who would then sell them to hedge funds and money managers. Now more home owners took out loans to “flip that house” to earn a quick $100K, and suddenly that $100,000 home is $500,000. CDOs were a great way to diversify a portfolio: non-equity securities with equity-like returns. When those really bad loans on the bottom of the CDOs went into foreclosure, the CDOs began to lose value. When the CDOs lost value, hedge funds lost value, and totally non-related industries and securities lost value.

Now the financial markets are extremely volatile. Disney’s short-term commercial paper is worth less than it was one month ago, and last week, investors were demanding more of Countrywide’s commercial paper than it cost Countrywide to service its own debt. In essence, its asset became a liability.

Experts with less foresight than I predict that home prices will “level off sometime in the near future.” But homes aren’t like stocks. You can’t buy back homes and add value like Intel can buy back stock to add value to other stockholders. You need a liquid market to accurately price something. But if there is no market to buy homes, why would anyone pay $800,000 for a poorly constructed stucco track house (with hardwoods and granite counters mind you). Home prices will continue to decrease because people simply can’t afford a home. No more free money and no-document mortgages.

The media will tell you home prices decreasing is a bad thing, but if you take yourself away from the drama of the situation, it’s clear that one can’t expect home prices to continue to increase indefinitely when inflation-adjusted median income is stagnant or decreasing. When income and the things you buy with that income go in different directions, and there’s no credit (fake money) to fill the void, you can expect that home price to keep decreasing until poor people like Rachel and myself can finally afford it. In the meantime, that lack of credit is hurting completely unrelated people like the chicken farmer in Romania. It’s true! Because of HGTV, home flippers, Wall Street, lax regulation, and myopic policymakers, that Romanian chicken farmer can honestly no longer afford the cost of credit to allow him to increase capacity or buy an apartment. He’s probably considered a subprime borrower anyway…