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For years, the residential real estate market boomed. Sub-Prime
loans—loans made to folks with poor credit—helped drive
this boom. The most important economic support for the boom
was easy credit. Interest rates were very low compared to
historical norms and the risk to lenders for making these
loans was also low because once made, lenders were able to
sell the contracts to other institutions, leaving themselves
unaffected if borrowers later defaulted on the loans.
Who eventually ended up owning those loans? They were
purchased by financial institutions who packaged them into
high yielding securities called CDOs (collateralized debt
obligations) which in turn were sold to hedge funds whose
shares were purchased by high net worth investors.
This was a good deal for a while as the value of homes were
bid up by the influx of new homebuyers and speculators able to
borrow on easy terms. These variable rate contracts obligated
homeowners to pay higher interest costs when interest rates
later rose. Some of these loans didn’t require any down
payment, so people were “owning” homes without any
equity interest in their home at all. Lacking experience and
good advice, new homebuyers didn’t understand what could happen
if and when interest rates rose. For many, this seemed like
their only chance to own a home. They hoped if rates did go up
later, by then they would be able to handle the increased
costs.
Eventually, the Fed did raise rates, mainly to control
inflation (the reality of which is often understated). But by
the time interest rates rose substantially, more new homes had
come onto the market than there were qualified buyers to
purchase them.
So the real estate market in many parts of the country
began to cool. As demand for new housing dried up, demand for
existing homes did too. With declining home values, many
homeowners owed more on their mortgages than their homes were
now worth. With interest rates rising, some of these
homeowners couldn’t pay the increased mortgage costs and
were forced to sell. But selling their homes didn’t cancel
the debt because their debt was more than the value of their
homes. Many of these loans went into default. As they
defaulted, the value of the securities into which these loans
were packaged declined precipitously and those high net worth
investors lost money.
So investors, who were once a source of capital for mortgage
lenders, once they began losing money, now wanted out of these
investments and money for risky loans dried up. Now buyers
with poor credit can’t get mortgages. With fewer people
qualifying for new mortgages and with so many people unable to
make payments on the mortgages they have, the downward
pressure on home prices is exacerbated.
Unfortunately, the fear associated with sub-prime loans
losses appears to be carrying over into other markets and now
other loans are hard to get too. Many people are arguing that
the Fed should now come to the rescue by lowering rates to
make it easier for individuals and businesses to get the
credit they need. But for the Fed, that presents a problem.
Essentially, the US is living on borrowed money and
borrowed time in the same way that many individuals are. We
borrow from China and other countries by selling them our
bonds. We borrow to fund our foreign military occupations and maintain our lifestyle.
Some countries may decide they don’t want to buy any more of
our dollar denominated bonds given that the dollar is likely
to be worth less later than it is now. Of course the Fed can
print money if it wants to, but printing more money when there
is not an equivalent increase in the amount of goods and
services being produced means more dollars are chasing the
same amount of goods and services. This bids up the price of
goods and services and we call that inflation. Inflation is a
reduction in the value of the dollar.
Inflation means things cost more then they used to. And
when things cost more than they used to, some families can no
longer afford to buy what they need or want. And if these
families have no savings to fall back on, the only way they
can get by is by borrowing on their credit cards or taking out
second mortgages. But Americans have been doing just that for
a long time now. Americans have the lowest rate of savings in
the industrialized world. Now a lot of folks have no savings
to fall back on and no more credit either. Many will need to
sell their homes, and some will go on welfare.
Americans will likely have less discretionary funds with which to
buy cell phones, dish washers, tv sets, and everything else.
This suggests that retailers are going to sell less,
unemployment will increase, and wages will stagnate. Times
will get tougher than they have been. The people who will be
hit the hardest will be those who are least able to cope:
those currently just making it on a fixed income; those who have
little savings and/or lots of debt;
and those who don’t have marketable skills. The middle class is
moving down a class.
What will this do to the stock market? Actually I don’t
know, I can only guess. But now stocks are riskier. People who
already have lots of money will buy stocks at bargain prices
when average Americans are forced to cash in their equities to
pay current living expenses. The gap between the rich and poor
will widen.
The wealthiest among us will end up owning more assets and
having more bargaining power over the rest. They will grow
their wealth by investing their capital and selling goods and
services where people have money… if not here, then in other
countries. America will begin to look less like a super power
and more like a lot of other places on the planet. Large
multinational corporations and the most well-healed players
will probably do ok. Inexperienced investors will continue to
invest in things they don’t understand and the stock market
will reflect the dislocations to which I’ve alluded, until
that which has been dislocated becomes the norm. None of this
had to happen. Mark’s email address is mark@gpln.com.
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