Donald Lambro's Dangerous Suprime Delusions

by: Michael Panzner

A visitor asked if I'd care to comment on a recent article by Donald Lambro. After reading "Subprime Shakeout Just a Rough Patch," my first inclination was to say "no," because I was tired and felt it was so far removed from reality that those who aren't caught up in the Wall Street-Washington fantasyland vision of today's America would see straight through it.

But then I reconsidered, thinking that it was better to err on the side of stating the obvious than to have some unfortunate soul fall for this farce of a spin-job and end up with nothing more than a one-way ticket to financial disaster.

According to Mr. Lambro, "no one can know for sure what the precise impact of the subprime-mortgage-market collapse will be." So far, so good. If he had stopped there, I would have said fine, I agree. However, he then adds:

But it is not going to deeply affect the long-term growth of our overall economy.

The reason: Our economy is too big, too resilient and its fundamentals too strong to inflict any long-lasting collateral damage to our economic infrastructure.

The number of subprime-mortgage bankruptcies and delinquencies is no doubt substantial, as last week's industry data survey showed, and we don't know how deeply that could dig into the larger mortgage companies. But reporting on this story, which rattled stock markets here and abroad, left out the financial context in which all this is occurring.

The subprime market's bubble burst -- as many predicted it would -- at a time when the economy overall was on solid ground. Corporate profits have been spectacular overall, small-business growth has been strong. A low unemployment rate ( 4.5 percent) has pushed total employment to nearly 150 million (the highest in our history), and wages have continued to rise.

The "economy overall is on solid ground"? What about the fact that the nation's personal savings rate and total debt as a percentage of gross domestic product have exceeded the dangerously unstable extremes last seen during the Great Depression?

"Corporate profits have been spectacular overall"? Yes, they have, but that is old news. Anyone who understands anything at all about economic history knows that the trend of corporate profit growth is one of the most reliably mean-reverting series in existence. In other words, there is only one way it can go from here, and that's down.

"Wages have continued to rise"? Most analysts who are not in some sort of substance-induced haze acknowledge that real -- inflation-adjusted -- wages have lagged economic growth for several years now. Clearly, Mr. Lambro is either smoking something or is being disingenuous.

But there's more to this bogusity:

Wall Street's doom and gloomers, who see a recession around every corner, are myopically focused on trade deficits, budget deficits and the housing downturn, while ignoring both United States and global economic growth.

"Myopically focused on trade deficits, budget deficits, and the housing downturn"? I don't know, I think a few are also focused on the projected $50 trillion-plus cost of social security, medicare, and other social programs that have not been properly accounted for. Or the $1 trillion of formerly hidden obligations, known as other post employment benefits, that state and local governments must now recognize under new accounting rules. Or the risks that stem from a $6 trillion financial safety net that includes government-sponsored disasters-in-the-making like Fannie Mae.

Still, Mr. Lambro carries on, spiraling downward like a heroin addict caught in the unrelenting grip of his destructive indulgences.

Somewhere in this story it may be a good idea to remind Americans that economic growth, as measured by the gross domestic product, increased by a robust 3.3 percent rate last year, and it will likely be in that range this year, too, said Fed chairman Ben Bernanke.

He is not alone in that forecast. Bear Stearns economist David Malpass, among others in the financial markets, said he expects "solid economic growth" this year and he thinks the housing slide and the subprime-market fallout won't be the disaster that hysteria-mongers predict -- for a number of reasons.

Other, less Polyannish forecasters -- i.e., realists -- see things differently. As I noted yesterday in "The Fed and the People: Looking in Different Directions," Northern Trust's Economic Research Department wrote last week that the index of leading indicators is flashing warnings suggesting "a recession is strongly likely." That is aside from the negative signals emanating from at least four other measures, including the yield curve, new-car sales, and construction permits, which I first mentioned in early January in "Cognitive Dissonance," as well commodity price trends, which I referred to 10 days later in "Mea Culpa."

As to the idea that the fallout from the subprime mortgage debacle will be limited, there have been a number of reports recently, some of which I have noted in recent posts, which make a compelling case that such optimism is unwarranted. Among the more recent comments are those by Sy Jacobs, Founder and Investment Manager at Jacobs Asset Management, in this week's Barron's. Here is a snippet from "Slow-Motion Train Wreck Picks Up Speed":

People who read our fourth of July 2005 interview with Sy Jacobs would hardly be surprised by the current meltdown in the subprime loan market. And it should come as no surprise that Jacobs, with a 23-year history of covering the financial markets, predicted the debacle. He has also shined as the principal of the $222 million Jacobs Asset Management in Manhattan, which includes a $45 million private-equity fund. Last year, his market-neutral financial fund gained 16.8% after fees, compared with 13.8% for the S&P 500. Since the fund's start nearly 12 years ago, it has returned 16.4%, on average, versus 11% for the S&P. He sees the debacle deepening, but spies opportunities, as well, in the adversity.

Barron's: Nearly two years ago, you saw the day of reckoning coming for subprime mortgage lenders.

Jacobs: When we spoke in 2005, I was worried about what was brewing in subprime, given the loosening in underwriting standards and the extension of credit to those with little equity and the inability to pay the loans back unless housing prices continued to rise. I'm surprised how long it has taken to unravel, but it has. Michael Farrell at Annaly Capital Management has been calling it the slow-motion train wreck, and the fact that it went on for another year or two since we spoke only makes it worse because the credit markets accepted more and more risk and got thinner and thinner margins while the party was still going on. The events of the past two weeks would tell you that the train wreck is accelerating and is turning into a contagion. Subprime will bring down mortgage lending, housing and, in turn, the economy and the market.

Some insist the problems in the subprime market are manageable.

The problems in subprime are not self-contained. It is a pinprick to a larger problem, and it needs to be looked at that way. The notion that subprime home-equity lending is somehow ring-fenced because it is only 12% of total mortgage loans outstanding and won't affect the rest of the mortgage and housing market is absurd. First of all, subprime lending was over 20% of 2006's volume. That tells you it was growing rapidly as a percentage of the mortgage business when it hit the wall.

It also tells you that the subprime borrower was increasingly the marginal buyer of housing and tilted the supply and demand of housing that resulted in such big increases in home prices until late last year.

How will the problems spread?

Mostly through housing. This year is going to be much worse than 2006 for mortgage and housing credit, and 2006 already laid the mortgage industry low. Nearly $700 billion of mortgages reset this year and nearly half of that is subprime. Remember 2004, when our esteemed former Federal Reserve chairman, Alan Greenspan, was exhorting us to take out adjustable-rate mortgages, the federal-funds rate was only 1% and had nowhere to go but up? Prime refinancing volume peaked in 2004, and the most popular loan product at that time was a 3/1 adjustable-rate mortgage, three years fixed and adjustable every year after that. Those are resetting this year after 17 quarter-point increases in the fed-funds rate. The subprime home-equity market peaked in 2005, and the most popular product from that year was a two-year-fixed, 28-year-floating mortgage. It resets this year, and now credit spreads are widening, Freddie Mac [ticker: FRE] is going to stop buying as much subprime, as are the capital markets in general, and a lot of capacity is exiting through bankruptcy courts.

The remaining players left standing are raising credit standards and cutting loan products and raising coupons on the products they continue to make. Housing hasn't bottomed, and it is just getting going to the downside.

How bad is the credit crunch?

It is spilling into the secondary market in the sense that credit spreads in the secondary market have widened in the past few weeks. We're seeing a reversal in the appetite for risk that we've seen for the past several years. Credit will get more expensive across asset classes, and that's another way in which the subprime contagion will spread.

It sounds to me that Donald Lambro should think twice before dispensing any more economic "wisdom," lest too many people get hurt by the fallout from his dangerous delusions.

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