What to Make of the Subprime Mortgage Crisis

Imagine yourself at a dinner party with friends. You’re in the kitchen, chatting with your host. Suddenly, the lights go out. What’s your first instinct? Rather than bolt for the exit, it’s likely you’d steady yourself against a counter and give your eyes a little while to adjust to the darkness before making a move. And, of course, once you acclimate yourself to the darkness, what seemed pitch black and unmanageable isn’t quite so impossible to deal with. In spite of your initial shock, after a minute or so, you can negotiate the room with ease, without bumping into your friends or furniture.

I advocate taking time for just that sort of adjustment in relation to the subprime mortgage crisis. Sure, the subprime meltdown has cast a pall over the economy, and your first instinct may have been to make a portfolio move. However, if there’s a piece of investment advice that holds true in any market, it’s that investors rarely are rewarded for sudden, reactive moves motivated by fear. So, take some time to understand what caused the subprime meltdown and adjust to the new financial landscape. I believe you’ll come away from your analysis further convinced of the value of a diversified portfolio of low-cost mutual funds.

A subprime primer

By way of background, subprime loans generally are pitched to borrowers with poor credit. Low “teaser” rates keep monthly payments smaller than those on fixed-rate loans for the same amount. However, after one, two, or three years, these too-good-to-be-true rates adjust annually, and that often leaves buyers paying significantly more than if they’d taken out fixed loans. In recent months, many subprime borrowers have had to stomach their monthly payments jumping by more than 30%.

Of course, the subprime meltdown that’s grabbed headlines in the past few months shouldn’t have come as a surprise. In fact, it’s the predictable result of a perfect storm. Lenders were willing to take excessive risk and buyers wanted in on a housing market they figured would continue skyrocket. Then, with credit extended to those who normally would not be able to qualify for a mortgage, demand for housing increased and anxious buyers bid up prices on an inelastic housing supply.

In no time, an already strong housing market was red hot, further convincing buyers with poor credit that it was worth the risk of overextending themselves over the short-term to participate in what would surly be stellar long-term growth. Many convinced themselves that by the time their mortgage payments increased a few years in the future, they’d have a hefty pay raises or, more likely still that the value of their property would have increased to such an extent that they could refinance their mortgage to draw on the equity they’d built in their home. Wishful thinking

The housing boom made possible by the easiest credit available in recent history wasn’t sustainable. As mortgage rates rose, in addition to devastating subprime borrowers, issuers that binged on subprime lending and hedge funds that made heavy bets in the sector also have been hurt. What’s more, the recent glut of foreclosures has caused a drop in housing prices and a pullback in homebuilding and, as an increasing numbers of mortgage holder’s default on their loans, banks worldwide that invested in bonds backed by these mortgages are facing big losses. Recently, for example, Bank of America Corp., a bellwether for the banking industry, reported “significant dislocations” in the capital markets sent third-quarter profits down 32 percent. (1) The subprime mortgage crisis also has spilled over into global financial markets. Experts have estimated that Deutsche Bank, Germany’s largest, will lose as much as 1.6 billion euros, or $2.24 billion, due to the subprime lending crisis. What’s more, Deutsche Bank announced this week that it wouldn’t be adding 4,000 jobs as planned due to these unexpected losses. (2)

Future fallout

Perhaps the most significant result of the subprime crisis will be the extent that those “For Sale” signs on lawns across the nation influence the American consumer’s psyche. We’ve already seen some negative impact. For example, an August survey conducted by the National Association for Business Economics (NABE) found that the combined threat of subprime loan defaults and excessive indebtedness has supplanted terrorism as the biggest short-term threat to the U.S. economy. (3) Eighteen percent of those surveyed pointed to the effects of the subprime debacle as their biggest concern, and the related issue of “excessive household and/or corporate debt” was cited by another 14%. Will we experience a housing-led recession or will home prices simply fluctuate aimlessly for several years without significant decline? Many experts agree that whether or not the U.S.is pitched into recession depends on consumer spending. Remember, consumer spending accounts for 70% of the economy. Over past 25 years, America’s rising consumer debt has been a stimulus to economic growth, if credit dries up and home loans are more difficult to come by, any resulting adjustment to our nation’s shop ’til you drop mentality could become a source of economic contraction.

Although the subprime crisis is a blip on the consumer’s radar screen, it’s worth noting a few real positive signs. First, consumer confidence received a boost recently when the major indexes took a major dive this summer, but have since recovered nicely. What’s more, the economy is strong in the sense that unemployment is low and layoffs aren’t eminent. Some experts say that’s what will make the downturn in today’s housing market different from the last housing crisis in the 1990s. Finally, this financial crisis is not as far reaching as the technology meltdown. Although you wouldn’t get this sense from reading the newspapers or watching CNBC, not all subprime loans are in default.

Those factors would seem to indicate that the “credit crunch” may not be big enough to pose a real threat to the economy. Because prime lenders’ balance sheets are strong, creditworthy borrowers still should have access to loans, enough to keep the economy humming.

Proactive steps

In another bright spot, Federal Reserve Chairman Ben Bernanke has called for the Federal Reserve, other regulators, and Congress to evaluate the recent subprime episode and decide what additional regulation may be needed to prevent a recurrence. Federally-sponsored firms like Fannie Mae and Freddie Mac may step in and help over-extended borrowers to refinance.

Importantly, on May 17, at the Federal Reserve Bank of Chicago’s 43rd Annual Conference on Bank Structure and Competition, the Chairman addressed the sharp increase in subprime mortgage loan delinquencies and noted a distinction between subprime loans for people who deserve mortgages and otherwise could not get them, and predatory lending practices that push people into loans they cannot afford. Said Bernanke, “In deciding what actions to take, regulators must walk a fine line; we must do what we can to prevent abuses or bad practices, but at the same time we do not want to curtail responsible subprime lending or close off refinancing options that would be beneficial to borrowers.”

While effective disclosures should be the first line of defense against improper lending, the Chairman concluded with a statement of faith in the market that reflects our own. He said, “Markets can overshoot, but, ultimately, market forces also work to rein in excesses. For some, the self-correcting pullback may seem too late and too severe. But I believe that, in the long run, markets are better than regulators at allocating credit.” (4)

In the meantime, financial-sector funds that have significant stakes in the banks and mortgage lenders may continue to be hit hard by the crisis. Consumers with low credit scores, even small companies, may find it more difficult to get credit. And, if you’re selling your home, your agent’s preoccupation with location, location, location may instead turn to financing, financing, financing. Rest assured that we will continue to monitor the subprime crisis to ascertain if the risk that’s now contained to specific sectors becomes something more systematic.

In conclusion, while some have floated the idea that the subprime crisis resulted because borrowers didn’t understand the terms of their loans, or banks got too fancy with the securitization of mortgages, the real root is really much simpler. Eerily reminiscent of the tech bubble, the subprime meltdown was caused by old-fashioned greed and a herd mentality. To help you guard against falling prey to your emotions, again, the best defense is a properly diversified portfolio of low cost mutual funds, the ability to discern between information and entertainment (i.e. investment pornography), and discipline to Stay the Course!

Additional Resources
For a more in depth analysis of the subprime crisis, you can read the new paper, The Housing Finance Revolution by Susan M. Wachter, professor of finance and real estate at Wharton and Richard K. Green, professor of finance and economics at George Washington University. They trace the evolution of the home-financing market over the decades, noting how technology, deregulation, globalization in financial markets, and a world-wide decline in interest rates have contributed to the current crisis. http://www.kansascityfed.org/publicat/sympos/2007/PDF/2007.08.21.WachterandGreen.pdf
Also interesting: “How We Got into the Subprime Mess” published online at Knowledge@ Wharton. http://knowledge.wharton.upenn.edu/article.cfm?articleid=1812

1) http://www.stockhouse.com/mediascan/news.asp?newsid=9392423
2) http://news.yahoo.com/s/mcclatchy/20070928bcbankingeurope_attn_

3) http://www.nabe.com/publib/pol/07/08/index.html
4) You can read the rest of the Chairman’s remarks at: http://www.federalreserve.gov/BoardDocs/Speeches/2007/20070517/default.htm

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