The Subprime Mortgage Mess

How the Subprime Mess Will Effect You

A Simplified History of the Subprime Mess

In 2001, we had the .com bubble burst, threatening to bring the country into a deep recession. In order to avoid that outcome, the Federal Reserve Board lowered interest rates to an artificially low level and kept them low for what many argue was too long.

This left many investors, including large financial institutions looking for some safe way to boost their yields.

At the same time, there was a lot of pressure on lenders to do away with "red-lining" of poorer neighborhoods and to expand home ownership to more families with lower incomes.

Added to this were real estate investors looking to take advantage of low interest rates to expand their holdings.

So the same geniuses who brought us the .com bubble went to work creating newer, supposedly "safe" ways to boost yields.

For some time, lenders had been "securitizing" all sorts of debt, from credit cards to mortgages, into packages that were sold to investors.

This allowed banks to lend more with supposedly less risk, since they were not worrying too much about getting paid back - that was the investors problem. (Unfortunately it turned out the banks were also buying these debt packages and using them to secure more debt.)

So all sorts of mortgage vehicles, many of which went by the wayside during the Great Depression, came back into vogue.

"No Document" aka "Liars Loans" lending became all the rage, 100% mortgage financing was freely available and exotic mortgage packages that few understood came into being.

Since the banks were not worried about repayment, many people who should not have been given a mortgage easily got one.

The financial geniuses of the world split the securitized packages into so-called "tranches" which is Wall Street speak for categories.

The highest risk mortgages were placed all by themselves into tranches which were used to boost the yields these financial institutions were allowed to offer to their customers.

For some reason, these geniuses thought it would be smart to use these tranches as collateral for more borrowing, thus intensifying the risk to the entire banking system.

In spite of many warnings that this was all very foolish, the game went on until late 2006 or so.

The Federal Reserve had started to raise interest rates again and borrowers with some of those exotic mortgage instruments were suddenly looking at negative equity in their homes and at reset mortgage payments they would not be able to meet.

Suddenly collateralized debt obligations were unsellable. Lenders had to mark these instruments on their books to market, incurring tremendous losses and forcing both lenders and investment funds into bankruptcy or liquidation.

Predictably houses started getting dumped onto the market. Foreclosures started to soar.

As the losses to investors and major banks started to soar, calls were made for relief and, just as predictably, the politicians started to jump into the fray.

The Bush Administration has set up a plan freezing certain mortgages at current rates for five years. Some of the major banks have set up programs to try to help the financially strapped - the last thing they need are more foreclosed homes on their hands - and the Federal Reserve - once again - is lowering interest rates.

Major financial institutions are being bailed out, in many cases by funds owned by foreign governments. Lawsuits will ensue.

There is no real way of knowing where the mess will end.

In the Spring of 2008, the entire worldwide fiancial system was on the brink of total collapse, causing the Federal Reserve to flood the markets with liquidity.

Some predications are that the market will sort itself out early this year, while more pessimistic pundits think we might be entering a ten year bear market in housing on top of an upcoming recession.

Home prices in hot markets like southern California have tanked, while other parts of the country are not doing all that badly.

However, new homes sales are way down and the sales of existing homes, while up, show a trend to substantially lower sale prices.

What to Do Now?

In spite of all the negative press, 94% or more of the mortgages in this country are current.

If you bought your house more than three years or so ago, you will probably find that it is still worth more than you spent for it. If not, unless you have an overriding need to sell, just enjoy your home and stop thinking of it as an investment.

The people hurt most are speculators and borrowers with little, no or negative equity in their homes. They are the ones who are putting downward pressure on home prices.

For the borrower who wants to keep his house, contact your lender - if it hasn't already contacted you - and see if you can work out something you can afford. Or wait to see what kind of bailout the government will give you. Remember, if the lender lets you walk away from negative equity or otherwise reduces your indebtedness, you might face income tax consequences.

If you are in the market for a house and have good credit, this is a fine time to buy. You might find the dream home you couldn't afford last year at 20% or more off.

If you are a subprime borrower, you have a problem. There might still subprime lenders around, but most are unwilling to take on new risk. So your ability to qualify will be much tougher and the terms of the loan will be much more onerous.

It would real pay off in the long run if you spent the next few years getting your credit score back up to 650 or so. You will find it much easier to qualify for a loan and the terms will be substantially cheaper.

Other Repercussions of the Subprime Mess

Unfortunately, it looks like the innocent bystanders to the subprime mess are going to suffer as well.

Market unbalances due to bailouts may throw the housing market out of whack for years to come. The bailouts themselves will likely lead to more foolishness by the so-called experts who now will know the government will cover their losses, no matter what they do.

Many investments that were thought to be safe, like certain money market funds may face losses due to subprime investments.

Interest rates will probably remain low for the time being, penalizing savers - although maybe rewarding stock investors.

And the dollar will continue to lose value due to inflation and oil prices will continue to rise due to the continued weakness of the dollar on world markets - meaning higher energy costs.

I personally side with the bears and do not believe the losses of the magnitude suffered will gently fade away.

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