My Views of Subprime Mortgage Crisis

The sub prime mortgage crisis is important and has far reaching consequences that will affect every single stock market participants in the near and long term. Despite what the main stream media says, this crisis is not an isolated and insulated event. This crisis will have a domino effect on the financial market, the equity market, the global financial market, and consumer spending.

One needs to see how we got into this mess in the first place. To facilitate a speedy recovery from the recession that began in year 2001, and to encourage liquidity in the financial world via consumer spending, Fed chairman Alan Greenspan embarked on fiscally liberal policy of interest rate reduction. The cheap money began to have immediate impact in the economy which facilitated corporate expansion and spending as well as consumer spending. It is the easy credit that encouraged people from all credit back grounds to drive the gas guzzling new SUV's to buying homes that couldn't be possible without the low introductory interest rates. From the rapid expansion of the hosuing market, need for more creative financing schemes were born in the form of sub prime mortgage fianciang packages. This proved to be a lucrative business as everyone began to jump into the "real estate bonanza" that soon followed. The housing market was humming that culminated in virtually everyone trying their hand at real estate investment. The sub prime mortgage industry was there to serve the needs of the investors, sub prime applicants, and other generally "prime" real estate customers to afford houses that were thought out of reach. The cycle was contagious and quick. Hybrid loans of all types flourished that teased applicants of these loans with up to 50 year terms and low teaser rates that adjusted with fed fund rates. Interest only loans were also popular and it was not uncommon to see someone making under $100,000 buying a home worth $1 million. The lenders both prime and sub prime was vigorously competing for customers that in the past wouldn't have even qualified. Risk assessment took a back seat to corporate greed and human greed. Virtually everyone that wanted a loan got one. Flipping homes with no intention of living in that property was popular and was for a time very lucrative. At its height, it was not uncommon for real estate investors to buy up spec homes in anticipation of price appreciation before the house was even built. This encouraged housing builders to over build and buy up land at ridiculously inflated prices. This had the effect of raising housing prices at unprescedented levels and the bubble was born. This came to a climatic end in the spring of 2006 and we are now mired in the mess that is known as post real estate bubble.

The problem that was created from the housing (real estate) bubble was inflation. Paper millionaires were being born every day. Due to the equity appreciation of homes, consumer went on a spending spree that rivaled any of those seen in this new era. Feeling rich, consumers spent lavishly on their home improvements, vacations, gas guzzling SUVs, and real estate investments. In 2004, the Fed began to raise interest rates from the historically low 0% to the current 5.25% in consecutive fashion which ended last fall 2006. The sad truth of the matter is that the Fed was preemptively popping the real estate bubble that threatened the well being of the US economy. The net negative that formed from this tightening activity by the Fed was the short term yield inversion in relation to the long term yield. This usually precedes a recession. When this yield curve inversion was brought to light in late summer, no one really cared and from July 2006 to February 27, 2007, we had a bullish rally in the stock market without any pull backs. In fact, there was no meaningful correction in the market place since 2004.

The ramification from the subprime market is many fold. The one thing the main stream media won't tell you is that sub prime mortgage applicants are not the only ones that participated in the interest only or hybrid loan packages. Even top candidates for mortgages were buying homes that were out of reach financially by employing these creative loan packages. In addition, many main stream banks such as HSBC, Bank of America, Washinton Mutual, and many others also competed against the likes of New Century among others for these willing mortgage applicants. Thus it would be erroneous to think that the sub prime fallout is only relegated to the sub prime mortgage companies. Secondly, wage growth did not keep pace with inflation. While job creation was also lagging. This has the effect of reduced consumer spending when the housing casino eventually ends, and we are close to that. The pundits will tell you that corporate spending will take over consumer spending to keep the economy afloat and that probably the economy will moderate growth to 2 to 3%. I do not think that to be true at all. The liqudity crisis is being averted at the moment by foreign investors in the US equities. Once that dries up, and as US goes into a recession that every knew was coming but chose to ignore, the fall out will be that there will be eflux of investment out of US and possibly into other emerging market or main stream markets. This will elicit increased inflation and slow job growth or stagflation, yet no one seems to even consider this as a possibility in the main stream media.

What will happen then? I think a good tell will be Goldman Sachs, Lehman Brothers, Bear Stearns, Morgan Stanley, all of whom has had significant exposure to the sub prime market in terms of lending, derivatives, and direct support of companies such as New Century. Do I think that a cautionary tone will be heard when Goldman Sachs (GS) reports tomorrow at 8 A.M.? I am eagerly waiting for the next shoe to drop. As goes the investment banking firms, so goes the rest of the economy. Therefore, while the main stream media is thinking that the rally will continue, the action thus far in the stock market has been to the contrary. Volume is lacking and the recent correction must be heeded. That it is a warning shot that there are dark times ahead for the US economy. It is time that we paid the piper. Those who aren't short or in cash may be in for a world of hurt. For the time being, let the delusional market players and main stream media continue to play the game of the Ostrich. I choose to stay hedged, short, and mostly in cash.