That Economic Roller Coaster

Over the last six months there has been a lot of talk about sub-prime lending and the state of the US economy. If one follows the news one can also see reports about the big banks doing this or that. This morning I caught part of a show on NBC called the Wall Street Journal Report. The report was very dumbed down, and the pundits had some “interesting” views. One thing that got me is they didn’t bother to explain why this really happened beyond saying “people getting the loans were misled”. The segment was so monumentally misleading I am nearly speechless.

I work for a financial firm. We deal in fixed income securities. What are those? They are mainly bonds. As a broker dealer we are the middleman between parties trading all sorts of bonds. I am simplifying what we do but that is a good basic definition. We also deal with the repo markets as well as mortgage backed securities which are both heavily affected by this. In this post I am just going to outline the sub-prime situation and not all the related parts. I’ll do that in a follow-up entry and then a third entry will tie it all together. The roots of the current economic situation go back to a specific type of lending. This lending is called “sub prime” lending.

What is Sub-prime?

Sub-prime lending is in simplest terms lending to people who are not “prime” loan candidates. What does that mean though? It means lending to people who could not get a loan under normal circumstances. They may have poor credit, no discernible income, or just be getting a loan they will not be able to pay. These loans are across the board from cars, to large retail purchases to mortgages. It’s mortgages that have been capturing the majority of airplay but it is really across the board.

These high risk loans were justified by higher interest rates and fees. There is also little regulation of this market. Some have called these practices predatory. They are at the least what I’d call shady. Lenders would expect defaults on these, and even had a way to make money off of these defaults. The problem was this method was a house of cards predicated on a strong housing and debt selling market. Once these went away you had massive problems come up.

The collapse

The sub-prime market collapse was caused by two things. The first of these was the drop in housing prices. There is even some evidence that the rise of sub-prime lending helped create the higher housing prices. In effect you had the housing bubble be created by, and help sustain sub-prime lending. This affected sub-prime mortgages in a big way. Houses were suddenly worth less than they were purchased for. So part one is the loss of mortgage value. These mortgages used to be sold back and forth. That stopped.

Combine that with the fact many of the smaller loans started being defaulted on as well. No one would wan that extra debt. While the banks have loads of cash they can only carry so much debt at once without feeling it.

Enter the debt load

This debt load used to be easily sold among the banks and lenders on the market. That was the whole point behind the creation of the MBS markets. They also expected, even wanted some people to default. They could make their cash back in auction and write off the lost interest. It was really a good situation if you were the lender. A good situation as long as you had someone willing to buy your debt.

What happens if the debt you want to sell is too hot? If it becomes too much of a risk? You have the sub-prime collapse is what. These major banks have millions in bad loans now that they cannot sell or recover. This has larger implication to the global economy though.

The Fallout

The fallout has had global implications. In the US the major banks have all taken large losses in the billions each. The exception being Goldman-Sachs which avoided the sub-prime market for the most part. There have been layoffs, spending cuts and even some CEOs have been fired. Among those who lost their jobs were the CEOs of Merril Lynch and Citigroup.

I’ve had some friends who have lost their jobs as well, they won’t be getting the million dollar packages for fucking up the company though. Globally we are seeing a number of lenders run into similar problems as seen in the US. Major losses are being reported worldwide. This has larger implications though. The sub-prime problems are only a part of the overall problems related to lending, spending and the US economy in general that we are seeing today.

How It’s Hit People

The worse impact has been to homeowners though. The map on the left (click to enlarge) shows the impact in the NYC area. As you can see the people defaulting are primarily poor and minorities. These people are not merely losing some cash, they are losing their homes. They are also taking a foreclosure hit to their credit rating which makes finding another place to live harder.

These people are not getting multi-million dollar packages to leave after totally screwing things up. They are risking their jobs, and their families after being sold a loan they could not pay off. A loan that the banks may have been hoping they would not pay off in the long term.

Read Part II – Larger lending woes, spending hits and the federal government.

Technorati Tags: citigroup, economics, loans, lynch, merril, mortgages, sub-prime, wsj