Rocking the subprime house of cards

Not quite everything is made in China.  From Asia Times Online: http://www.atimes.com/atimes/Global_Economy/IC06Dj...

Some stories, such as corpse custody battles between sleazy lawyers and semi-literate Texas trailer trash et al, the US news media handle really well. On others, such as goings-on in the world's financial markets, they don't have a clue.

Thus the media saw the big February 27 decline in the Chinese stock market followed by a big decline in the US and in other world financial markets that same day, and decided that being coincident equaling being causative was a concept that the US public could get its mind around pretty easily. Suddenly it's all China's fault.

Mind you, the US media know they will always do well by blaming foreigners, especially non-Western foreigners, for problems of essentially domestic origin; had he not died in 1991, you would have half-expected to see Khigh Alx Dheigh, the actor who played the nefarious Chinese communist operative Wo Fat in the 1970s US television crime drama Hawaii Five-O, displaying his trademark evil smirk while taking credit for the whole thing on Fox News.

People who make their living trying to ride and tame the living creatures that are traded in financial markets approach the issue of causation, of "why" something happens in the markets, with no small measure of trepidation. Sometimes determining cause is easy; if you see that a pharmaceutical firm's stock is down sharply, and then you see a report that the company's new chemotherapy drug kills more than it cures, well, in that case, putting one and one together is fairly reasonable. In other cases, and especially regarding the market as a whole rather than just an individual stock, "why" can be a fairly tricky question to answer. As then-US Federal Reserve chairman Alan Greenspan said in congressional testimony regarding the panic selling of the 1987 US stock-market crash, "Why were stocks going down? Because people were selling. Why were people selling? Because stocks were going down."

For those who make their living in markets, the logic is impeccable.

This time, was it China? For one to believe that it was would require that Chinese stock prices and values, and by extension the Chinese stock market in general, were so large and important as to occupy an absolutely central position in the world economy. The Shanghai Stock Exchange, China's equity-trading benchmark, is divided into two sections. The A-shares, which took the big hit on February 27, consist of 825 listed share companies. Foreigners are mostly forbidden to hold or trade A-shares, which certainly makes it a bit harder to swallow the idea of a worldwide equity meltdown spreading out of the A-share market resultant from foreign investors selling equities on a global scale to cover their Chinese losses. The part of the market open to foreigners, the B-shares, is much smaller, comprising about 55 listed companies.

So a 9% one-day decline in a market that had doubled in the past year, taking prices back to where they were less than two months ago - a market that is in essence closed to foreign participation -caused a global stock market rout that, in the United States at least, wiped out US$630 billion of stock equity value just in one day?

Possible? Sure, anything's possible. But it's damned unlikely.

A 9% loss is bad, but you could always make it up. Markets do recover from losses. What's a lot worse is a 100% loss on your investments. Total wipeout - you don't recover from that. A lot of investors who thought they were making canny and sharp investments over the past few years are now facing this prospect, and the possibility of a cascading stream of successive defaults and bankruptcies is hanging over the financial markets like a specter.

In the US, it's called "subprime lending".

In olden times, young bankers had drilled into them the adage that "if the bank lends a man $1,000, the bank owns him; if the bank lends a man $1 million, the man owns the bank". Large loans have, by the possibility of loan default implicit in all private lending, the potential of bankrupting the bank and then starting a chain reaction of defaults among other banks. So bankers were taught the importance of careful, cautious, prudent lending.

Prudent lending. For modern bankers, that might ring a bell, something they read in a dusty old tome they once glanced at in the business-school library.

Back in the days of It's a Wonderful Life, the mortgages that George Bailey wrote from the Bailey Building and Loan originated in Bedford Falls, and they stayed in Bedford Falls. George Bailey could say what no modern mortgage banker could: "Your money's in Joe's house right next to yours. And in the Kennedy house, and Mrs Macklin's house, and a hundred others. Why, you're lending them the money to build, and then they're going to pay it back to you." [1]

And the banks where the mortgages originated, they were different, too. Sound and strong buildings occupying the center of town, often adjacent to those other institutions of worldly authority, the courts and the police; these solid stone and brick edifices virtually screamed out their probity and good judgment.

In the US, real-estate lending sure is different today. There are a lot more lenders these days; banks are in competition for the mortgage market with what are called "mortgage brokers". These do not occupy the august moneychanger temples of the past; you might find them at the end of a strip mall next to the Dairy Queen; in rural areas, you see them in little structures cut out of the forests on the side of two-lane country roads.

The mortgage lenders are different because the mortgage market is different. There are no more George Baileys who make and hold mortgages to maturity. Instead, these days, virtually all US home mortgages are packaged and bundled together to become what are called "collateralized mortgage obligations", or "mortgage-backed securities". The bank or other mortgage originator that constructs these packages sells them to investors, who use them very much as investment bonds. Thus your monthly mortgage payment, instead of going to the bank that you write the check to, now "passes through" as a dividend payment to the investor who bought the package of mortgages that contains yours. Since the mortgage business now involves far less of a lifetime commitment between borrower and lender, the way is open for all these new storefront mortgage enterprises, for all they exist to do is to sell the mortgages they write into what is called the "secondary" market.

What the investor in these bundled mortgages gets are interest rates, dividend payments, in between one and two points richer than those available on US Treasury securities of the same maturity. For all its faults, this system (along with preferential tax treatment for real estate) has given the US, at 70%, the highest rate of owner-occupied housing on Earth, and it is a system that many nations, including the formerly communist economies of the Eastern Bloc, have moved to adopt over the past 25 years.

But, done to excess, everything good becomes bad. Thus the chain of events that led to last week's stock-market falls.

The one- or two-point spread of these instruments over Treasury yields represents what highly creditworthy mortgage borrowers pay for their loans. What interest rate do you pay for your mortgage if your credit status, your credit "score", isn't quite up to par?

Like if you've had so many cars taken back by the banks you know the birthdays of the repo man's kids. Or if it has been so long since you made a payment on your store charge cards that they slam the security gates shut when they see you.

In the old days it would be easy to calculate what mortgage interest rate these borrowers would pay - zero. These borrowers would not get mortgages; they would forever be renters. Then the mortgage industry had a neat idea.

Instead of denying these less than fully creditworthy borrowers mortgages, let's give them loans, only at a much higher interest rate. Instead of having them pay 1 or 2 percentage points over US Treasuries, they'll pay 3 or 4. We can then bundle, or "securitize", these mortgages into high-yield bonds. (Some bond investors became addicted to the double-digit bond yields in the early 1980s, and over the past two decades have again and again proved themselves more than willing to "reach for yield", to take on significant extra risk to get another fix.) Sure, there might be more defaults on these mortgages than you'd see from high-quality borrowers, but the higher interest rates would more than make up for a few defaults and repossessions here and there, and besides, as long as real-estate values continued the meteoric rise of the early and middle part of this decade, the subprime borrowers could soon use the new extra equity in their home's values to refinance into more prudent borrowing arrangements.

Thus all the ingredients were in place for the real-estate frenzy that gripped the US, and much of the rest of the capitalist world, over the past few years. With the tremendous new demand from this cadre of buyers now able to get the housing finance once denied them, and with new supply a lengthy process, there was suddenly a significant imbalance between demand and supply in the US housing market. Other mortgage finance innovations, such as low initial "teaser" rates, interest-only mortgages, or the spread of floating rates, allowed more and more people to move into properties they couldn't really afford.

When prices took off, this attracted more buyers, more demand in the market, and the price-appreciation cycle became self- reinforced. Soon, people were paying close to $1 million for one-bedroom condos in San Diego or Miami Beach, and they were happy to do so; they thought they were getting a bargain. By 2005 and 2006, between 25% and 33% of all newly written US mortgages were subprime, but this was thought to be okay. The borrowers had their homes (or they thought they did), the investors had their high-yield securitized mortgage bonds, and incumbent politicians could point to the healthy home-ownership numbers as proof that the mighty American dream still rang strong and true.

Just about the time that soaring real-estate prices were replacing celebrity sex as the central obsession in the US psyche, something funny happened. Price rises slowed or stopped; in some of the hottest markets, home prices actually began to decline. Between June 2004 and June 2006, the US Federal Reserve raised short-term loan rates 17 times. Starting at 1.25%, the Fed eventually drove them up to today's 5.25%.

Floating rate mortgages had their rates tied to these Fed rates. For those mortgage borrowers who only got into their homes by being able to handle a floating rate payment that started with the low payment implied by a 1.25% Fed rate, this meant a big mortgage-payment increase. These borrowers could barely qualify for loans and then handle the payments calculated with the low rates; when the mortgage payments were recalculated to reflect the higher rates (were "reset" in mortgage jargon), they would be unable to pay the mortgage. The rise in mortgage interest rates, along with the fact that in the areas where the price appreciations had been the craziest, prospective buyers soon realized that everybody in the household up to and including the family pet would have to work two or three jobs to generate enough income to afford the payments inherent in the $700,000 selling price of a two-bedroom rambler, finally broke the back of US housing's wild ride.

The warning flags have been flying for months, but with every five-point rise in the Dow index being wildly celebrated as another glorious new record, another gushing multiple orgasm in the fabulous orgy of US market capitalism, the US media ignored the story that it should have told in favor of the one it wanted to tell.

On February 7, HSBC Holdings, formerly called Hong Kong Shanghai Bank Corp, warned of massive forthcoming losses, arising mainly out of problems at its US subsidiary, Household Bank, a leader in subprime lending. Another big subprime lender, New Century Financial, did the same. Along with the waves of real-estate foreclosure notices now piling up in the clerk of court offices in the former hot markets, the markets slowly started to realize what was, for the lenders anyway, a very inconvenient truth: a lot of these mortgages were never going to be paid back. A lot of major financial institutions that had invested in subprime mortgage debt, not just HSBC and New Century, were looking at very serious balance-sheet problems.

A lot of wags have noticed that for the US stock market, bad news is frequently treated as good news. Unemployment is up, or industrial production is down, and stocks rally (due to attendant possibility seen in these reports of upcoming Fed interest-rate cuts). However, when major financial institutions have what are delicately called "liquidity issues" (ie, their loans aren't being paid back - they have no income), that is always bad news. What if the bank defaults, declares bankruptcy? Other banks that it had borrowed money from now won't be getting paid back, they'll lose whatever income stream they were receiving from the first bank. The same with that bank's creditors, and then other banks and so on.

This kind of cascading financial catastrophe is often called a "contagion", and with good reason. Like a virus, it can spread and bankrupt the entire financial system. It almost did in 1998, during the LTCM hedge-fund crisis; in 1929,in an era when the worldwide financial system was far less globalized and integrated than it is today, after the Great Crash it actually did, and so initiated the Great Depression of the 1930s.

Is it over? Not necessarily. Two little-known indicators that more investors should be cognizant of are what are called the VIX and VXN indicators. (Put these letters in the stock symbol line of your quote website; they should come up - watch how their values move inversely to stock prices.) Technically, what these two indices measure is what is called stock-option volatility (stock "beta", in jargon), but what they really tell smart investors is just how much fear there is in the markets. When these levels get very high (roughly above 30 in both indices; after the selling caused by the Enron corporate-management scandals of 2002, the VXN actually topped out over 70), it indicates that the market has seen so much fear-driven panic selling that, by the rules of what is called contrarian investment philosophy, stocks are due for a turnaround. As of the first weekend in March, neither index had reached those extreme levels.

So it's not China. It's not Nancy Pelosi, it's not the Easter Bunny, nor is it the War on Easter. It has been said that all market psychology, all market movement, is a continuous oscillation between the mental polar opposites of optimism and pessimism, between greed and fear, between Pollyanna and Cassandra. Since at least the market rally that started in early 2003, optimistic Pollyanna has ruled the markets, and greed has run rampant. As the markets wait for Fed chairman Ben Bernanke to put on his best Donna Reed mask to bail out the subprime lenders with the Bailey family's honeymoon money, Cassandra and her fear are ruling the day.

Note1. Frank Capra's 1946 film It's a Wonderful Life starred James Stewart as George Bailey and Donna Reed as Mary Hatch Bailey. Julian Delasantellis is a management consultant, private investor and professor of international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.