Subprime Bust: Everyone May Suffer the Consequences

by: Tim Iacono

There is a bit of a love-hate relationship here with Bloomberg columnist Carolyn Baum. She's been both derided and praised in this space before, sometimes in the same week. When she dismisses commodities as an investment class or writes about "tin foil hats" and "black helicopters" as they relate to financial markets, she's oftentimes referred to as 'The Baumer".

But when she has harsh words for former Fed Chairman Alan Greenspan and the bubbles that he left behind, then she is adored.

Well, that was probably going too far - maybe 'respected' is a better word.

Ms. Baum's column on Monday, where she ruminates on the meltdown currently underway in sub-prime lending while thinking back on some of the former Fed Chairman's sage advice, is an example of the latter.

Banks That Took Greenspan's Advice Pay the Price

It was bound to happen sooner or later, an out-of-the-blue reminder that the froth or the boom or the disconnect between prices and fundamentals in the housing market would have a financial after-shock.

HSBC Holdings Plc, Europe's biggest bank, dropped a small bomb last week when it announced that it was setting aside more money as a cushion against the accelerating pace of loan delinquencies. Yes, Virginia, subprime mortgages -- home loans to folks with a spotty credit history -- do carry some risk after all.

In addition to making those loans, HSBC bought packages of subprime and second-lien loans from other mortgage originators. It seems the best models HSBC's quants could design didn't adequately reflect the inherent risk in lending to deadbeats when house prices stop soaring.

Before folks could say, "sell,'' New Century Financial Corp., the No. 2 subprime lender in the U.S., delivered its bad news, saying it would have to restate 2006 earnings because of an increase in loan-loss provisions. The stock lost 40 percent of its value.

Isolated examples? Probably not. Confined to the subprime market? Doubtful.

"There is no way the conditions that existed in the subprime market between borrowers and lenders weren't a multiple of what went wrong,'' said Michael Aronstein, chief investment strategist at Oscar Gruss & Co. "The incentives are perverse. You're paid for volume, not for being a schoolmarm.''
...
The danger comes when the financial system is impaired, as it was in the early 1990s in the U.S. and during the 1990s and part of the current decade in Japan.

Sage Advice?

That's when the Fed would start to get concerned about the ramifications, which so far have been limited to a decline in the prices of subprime mortgage bonds and the stocks of mortgage lenders.

It's too soon to know the extent of the problem from all the option ARMs (the interest is optional, but the principal is not!). Only three years ago, former Fed Chairman Alan Greenspan said homeowners could have saved a heck of a lot of money had they opted for adjustable-rate mortgages during the past decade.

Ex post, that was good advice. Ex ante, it's not looking good.

"American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed- rate mortgage,'' Greenspan said in a speech to the Credit Union National Association in Washington.

Lenders took his advice. Borrowers jumped at the opportunity. Everyone may suffer the consequences.

Yes, it was only a few years ago that both Alan Greenspan and National Association of Realtors Chief Economist David Lereah were encouraging homeowners to take on adjustable rate mortgages and other largely unregulated, non-traditional loan products.

Mr. Lereah even went on to imply that you weren't very smart if you didn't.

Neither of these two are looking very smart at the moment. They have been two of the more conspicuous voices in the "2007 housing rebound" story that seems to lose a little pace with each new report of difficulties in servicing credit that has already been extended.

Lending practices of the last few years did wonders for the economy in the short run.

The longer-term impacts for both the mortgage lending industry and the business of real estate remain to be seen - given recent developments in subprime lending and with interest rate resets due this year, we won't have to wait too long to see how this turns out.