Has the subprime crisis been contained? The men in charge, Ben Bernanke and Henry Paulson, seem to think so, but readers should realize that they did not even acknowledge the existence of a problem till it surfaced.
Investment gurus such as Jim Rogers (“one of the biggest bubbles we’ve ever had in credit and the subprime rout has a long way to go”) and Bill Gross (“… the biggest real estate collapse since the Great Depression”) have made forecasts that I find more in sync with my opinion. The subprime mess is merely the proverbial “tip of the iceberg” and, in the months ahead, we will see a similar issue with prime mortgages as well.
Ultimately, the popping of the housing bubble will send the US economy into an extended recession either later this year or early next. The foundation for the housing bubble can be traced to the Fed-induced reinflation after the dotcom collapse in 2001. With the Fed funds rate at a six-decade low, real estate became the obvious candidate to attract money. Like all bubbles, the initial increase in asset prices attracted a new set of buyers and the process fed on itself. But what transformed a rising market to one that history will probably judge as the biggest real estate bubble were four factors:
1. Lax lending standards: Till about a few years back, banks routinely conducted an honest assessment of the buyers’ ability to repay and insisted on a 20% down-payment as proof of the buyer’s commitment to the purchase. This also ensured that a buyer did not walk away from the deal at the first sign of a price decline. From a situation that was designed to protect the lenders’ equity to a situation today where a bankrupt person, without a job and without any documentation, can get a million dollar, interest-only loan has been a transition that seems to be designed for a bubble formation.
2. Adjustable rate mortgages (ARMs): With long-term interest rates at a historic low, why did a huge percentage—an estimated 75% of subprime loans and 40% of all loans—of buyers commit to ARMs that offered only the downside risk with very little upside (an interesting point to note is that “Bubble Man” Alan Greenspan encouraged people to take out ARMs at the bottom of the interest-rate cycle)? The reason lay in the initial teaser rates that offered a much lower rate for the first couple of years before resetting to normal levels. Sophisticated versions of ARMs included interest-only and negative amortization loans that made the initial payments even lower than what ARMs did. Buyers, whose only motivation was an appreciating home value, which would take care of the future higher payments though equity extraction, couldn’t care less.
3. Subscription to mortgage backed securities (MBSs) by foreign banks and private equity funds: Wall Street came up with sophisticated products where all the subprime and Alt-A loans (a type of risky loan) were combined to deliver an AAA rated bond that was readily purchased by the foreign banks as they offered a better alternative to the low-yielding US treasurys. Though the underlying asset behind these securities was suspect, the purchase of MBSs allowed these organizations to report initial higher returns.
4. Consumer speculative behaviour: There are examples where students studying in colleges took a housing loan figuring out that the increase in house prices would cover their entire tuition fee. Besides, home equity extraction became the new “credit card” with US consumers borrowing money against the appreciated value of their houses. The owners’ equity as a percentage of home market value has now fallen to a little more than 50% from more than 70% in the early 1980s and this should be viewed against the substantial increase in house prices over the years. Imagine what this number would look like when house prices decline to more normal levels. Homeowners are soon going to realize that the only thing “real” about their housing wealth is the liabilities!
The first three factors, if not all four, have now all but vanished. So to assume that house prices would stabilize in the absence of the legs that were artificially propping them up is wishful thinking. By some estimates, the US has housing inventories to last for the next 5-10 years at normal economic growth rates. Given that the growth itself was propped by rising house prices (43% of all jobs created over the last five years were related to housing, according to a Northern Trust Company study), who knows how long it is really going to take to clear the inventories?
This resembles the bursting of the Nasdaq bubble, when the stocks first to collapse were the no-brainers such as Webvan and Amazon. But these were soon followed by companies with “real” earnings such as Cisco and Dell due to their extreme valuations.
The worst case scenario in my opinion is not the popping of the bubble. Even worse would be a situation where the Fed tries to maintain the nominal value of housing by a combination of reinflation and lowered interest rates. If the foreign buyers of US treasurys woke up to the game, the dollar could plunge overnight.
(Shanmuganathan N. is director Benchmark Advisory Services. Comments are welcome at firstname.lastname@example.org)