Tuesday, March 13, 2007

Unassisted Private Sector Correction

Crash, burn, gone. The subprime mortgage market collapses and the tremors shake up the stock market. Mark Gongloff of the Wall Street Journal covers the basics and Bob Ivry of Bloomberg speculates about far reaching consequences for the housing economy.

Falling Shoe Zone: Well, that was ugly. … It was the second-worst day for the market in nearly four years, after the meltdown on Feb. 27. Financials took it on the chin, with the Dow Jones Financials Index falling 3% on the day. … About a year ago, we wrote a Trading Shots column wondering whether the Fed was going to create a financial train wreck with its rate-raising campaign. … Maybe this subprime fiasco is that meltdown.

Foreclosures May Hit 1.5 Million in U.S. Housing Bust: The spring buying season, when more than half of all U.S. home sales are made, has been so disappointing that the National Association of Home Builders in Washington now expects purchases to fall for the sixth consecutive quarter after it predicted a gain just last month. ``The correction will last another year,'' said Mark Zandi, chief economist for Moody's Economy.com in West Chester, Pennsylvania. ``Fewer people qualifying for mortgages means there will be less borrowers, and that will weigh on demand.''

The mortgage industry makes money by selling loans to secondary market investors. To make more money they need to sell more loans and to sell more loans they need to approve more borrowers. In other words, the lenders wanted to expand the pool of eligible borrowers so that is exactly what they did.

New loan products are designed and priced specifically for individuals with bad credit, limited finances, or for speculative purchases. The math works perfectly as long as the borrowers make the payments. This last month however, defaults reach historic levels. The busted speculators simply walk away while over leveraged households just run out of money. The institutions that purchase bundled packets of loans for the long term income stream are not happy as default dwindles the cash flow. Two weeks ago – the day of the 416 point DOW drop – one of the big players cries ENOUGH!

Freddie Mac Announces Tougher Subprime Lending Standards: February 27, 2007 Freddie Mac (NYSE: FRE) today announced that it will cease buying subprime mortgages that have a high likelihood of excessive payment shock and possible foreclosure.

Within hours, all of Wall Street follows suit and suddenly – poof – the entire private market for subprime loans vanishes. Mortgage companies instantly find themselves stuck with worthless assets. If you have nothing to sell, you have no money to lend. For some it is time to close up the shop and go find other work.

Now that the shoddy addition to the housing market has crumbled, the speculation about the remaining market begins. Two Views on the Mortgage Mess finds optimists and pessimists at the same paper. A larger danger lurks in congress where politicians dream of rushing to the aid of poor constituents loosing their homes. It could be taxpayer Bail Out time!

1st Helicopter Drop Now Being Organized: U.S. lawmakers will have to consider providing aid to about 2.2 million subprime mortgage borrowers who are at risk of defaulting and losing their homes, Senate Banking Committee Chairman Christopher Dodd said today. … The market has now taken care of subprime lending (or rather is in the process of doing so) and any bills Congress passes at this point are just going to cause additional distortions. ... It's high time Congress spares us the Dudley Do-Right Charge in favor of letting the market take care of it. But no! Congress never learns.

The market is doing what markets are supposed to do – cease to reward bad business decisions and high risk financial behavior. Life is full of hard lessons and experience is a wonderful teacher. Now if we can keep the government from interfering, the healthy aspects of the economy will adapt and keep going.