From the Sub-Prime to the Ridiculous

Written By Brian Hicks

Posted March 16, 2007

Dear Reader,

Here in Santiago, Chile, the sun is bright. The future is also bright for the national economy of Chile, but as many U.S. investors and homeowners are now learning, capitalism can bring cataclysm if not carefully implemented. Today’s commentary from Peter Schiff highlights the theater of the absurd that sometimes unfolds in boardrooms and trading markets. I will return home to chilly Baltimore next week, after talking to Chile’s leading financial experts. We must address market shocks even in the most advanced economies, so I will ask them exactly how an emerging market best copes with events such as the sub-prime debacle. Stay tuned for more from Chile, and enjoy Peter Schiff’s insight today.



Sam Hopkins




From the Sub-Prime to the Ridiculous

With the meltdown in the sub-prime mortgage sector now laid bare, many on Wall Street desperately cling to the notion that the pain will be localized. The prevalent delusion is that the overall mortgage, housing and stock markets will be little affected by the carnage ravaging the sub-prime sector. Therefore, renewed stock market weakness is seen as an overreaction and a great buying opportunity. These assumptions represent wishful thinking in the extreme.

Those who think that the sub-prime market is unrelated to the broader economy do not understand that the problem is not just the fiscal responsibility of marginal borrowers, but the inherent weakness of the entire U.S. economy. It’s just that the sub-prime sector, being one of the most vulnerable spots, is where the problems are first surfacing.

Think of the U.S. economy as an unstable dam. The first leaks will be seen in the dam’s most vulnerable spot. But there will be many more leaks to follow. Before long the entire dam will collapse. It would be a fatal mistake for those living downstream to assume a leak is an isolated event, unrelated to the integrity of the dam itself. But that is exactly what people on Wall Street are doing with respect to the horrific data emanating from the sub-prime market.

The bottom line is that far too many Americas, not simply those with low credit scores, have borrowed more money then they are realistically capable of repaying. The credit boom was created by initially low adjustable rate mortgages, interest only or negative amortization loans, and an appreciating real-estate market that allowed homeowners to extract equity to help make mortgage payments. Now that real-estate prices have stopped rising and mortgage payments are resetting higher, borrowers can no longer "afford" to make these payments.

Significantly, most sub-prime loans involved low "teaser" rates that lasted for only two years. In contrast, teaser rates for most prime ARMs typically last for five years. This difference, rather than any inherent distinction in the fiscal health or creditworthiness of the borrowers, explains why the delinquencies are so much higher in the sub-prime sector.

Of course, the vast majority of home loans in the last few years, sub-prime or otherwise, should never have been made in the first place. But when real-estate prices were rising, no one cared about the wildly optimistic assumptions or the out-and-out fraud inherent in the loan process. Everyone was making money. Borrowers, regardless of their ability to pay off their loans, thought they were getting rich as real-estate prices rose. On the other side, homebuilders, real-estate agents, appraisers, mortgage brokers, mortgage originators, Wall Street brokerages that securitized the loans and the hedge fund clients who bought them were all getting rich as a result of booming credit. For the charade to continue, borrowers pretended they could pay and lenders pretended that they would be paid.

The fix now being suggested by some members of the U.S. Congress demonstrates how Washington completely misunderstands market dynamics. Their legislative proposals will require that lenders make potential borrowers verify their incomes and restrict credit to those who can afford the payments after the teaser periods end. Washington fails to grasp that a return to traditional lending standards would precipitate a return to traditional prices, which are way below current levels. There is just no way to crack down on lenders without causing a crash in the real-estate market. But continuing to look the other way is no panacea either, as the real-estate market is already in the process of collapsing under its own weight.

It is also typical and very disingenuous for lawmakers to feign outrage, or to wait until a collapse occurs before taking action. As with the Internet bubble of the late 1990s, the politicians refused to act in advance of the crisis. Had the government taken preemptive action with regard to mortgage lending, the real-estate bubble never would have been inflated to the degree that it has. But a slower housing market would have resulted in a much weaker U.S. economy. More modest home valuations would not have allowed consumers to cash out phony real-estate wealth. Instead, homeowners would have been forced to make higher mortgage payments and had even less money to spend on consumption. They might have actually considered saving some money for the future, as their homes would not have been doing the "saving" for them.

In reality, the problem goes way beyond housing. Nearly every big-ticket item that Americans consume is paid for with borrowed money, with foreign lenders supplying the credit. Without access to low-cost credit, the spending stops. When the spending stops the service sector jobs associated with robust spending will disappear as well. Without paychecks, even those with low fixed-rate mortgages and high credit scores will not make their payments.

The bursting of the technology stock bubble of the 1990s was simply the opening act. What we are about to experience with the real-estate bubble is the main event. In that respect, though it may be March of 2007 it sure feels a lot like March of 2000. But instead of a mild recession, this collapse will be followed by the most severe recession since the Great Depression. The main risk is that Ben Bernanke and his buddies at the Fed could panic, producing something far worse; a hyperinflationary bust similar to the one experienced by the Weimar Republic in Germany. Let’s hope that cooler heads prevail, but get your wheelbarrow ready just in case.

For a more in-depth analysis of the U.S. economy and why it is in so much trouble, read my new book "Crash Proof: How to Profit from the Coming Economic Collapse." Click here to order a copy today.

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