That Economic Roller Coaster Part II.

In my previous entry - The Economic Roller Coaster Part I I discussed the sub-prime lending market and how it has collapsed in a spectacular fashion with all sorts of repercussions. In this post I’ll outline some of those repercussions and attempt to show some of the links between all the pieces.

Sub-Prime and Housing Prices

Over the summer sub-prime lenders took a huge hit due to a combination of a large numbers of loan defaults and housing prices drops. There is evidence that these two factors may be related. Some research has shown that housing prices remain high when people are paying off their loans, once that stop however the opposite occurs. The cause? A combination of factors really. You do have a supply increase as more homes are foreclosed on. Was this enough to push things into the spiral we are seeing? That is unclear, but it has not helped the situation. It’s just one of the factors involved really.

A sign around the corner from me.

The other factors which affected housing prices have been the difficulty in getting a loan. Sub prime loans have become scarce now for good reason. This will help depress housing prices. The large loans are simply not there for people to buy. So they don’t buy, or buy for less. Initially we’ve seen housing drops of about 5%. Doesn’t sound like much? Well when you have homes already overpriced that small a drop can cause all sorts of problems. Especially when the bank wants to auction a foreclosed home. There are some estimates of a total price drop of 30% or so when all is done. Now is not the time for short term property investment. Prices are reflecting it.

These factors combined to help move sub prime into a big hole. It was already a house of cards, and once prices started dropping it fed into the increasing debt that no one wanted to buy. But that is only a small part of what is happening. Another, potentially larger concern is what is and will happen to people with Adjustable Rate Mortgages(ARMs). The effects here will be felt for many years to come.

Vendor Lock-in: Mortgage Style

An ARM, Adjustable Rate Mortgage, is a mortgage where the interest rate will change over the course of the loan. Many people have gotten these loans so they could afford a house that under a normal loan would not be possible. It works in a fairly simple manner on paper. You get X low percentage for Y years. After Y years the interest rate jumps up.

The ARM is a somewhat controversial loan because it can be easily misunderstood and get a borrower into serious trouble quickly. From the lenders perspective though it’s a good deal. They can, within limits, adjust the interest rate and increate their profit on the loan. The only real recourse a borrower has at that point is to refinance the loan, taking out a second mortgage. The borrower basically just keeps extending their debt. It’s a nice little trap really. In the computer industry we’d call this vendor lock-in.

There are other kinds of loans that apply here as well. The interest only loan is a good example of a loan affected by housing price drops. These loans rely on housing prices going a certain way. You don’t build equity under an interest only loan so a second mortgage on this kind of loan is not really possible. Now combine this with an ARM and you get true insanity. The worse part is this stuff is completely legal. While there are controls on how far these can go you can still get yourself into major trouble if you are not careful. Another computing principal comes to mind here: KISS (Keep It Simple, Stupid). It’s really easy to get yourself in trouble with these loans, read on for an example.

A Simple Scenario

Let’s look at a simple scenario. Tom and Jane see a big house, it comes with lots of bedrooms and bathrooms, a white picket fence, even a tree for timmy to build a fort in. They see the price and think “we can’t afford this.” In comes Shady McLender who shows them a magic way to buy it. The ARM! It’s awesome and can give you that big house. Just buy now and refinance later! So they get the house and the loan. All goes well at first. Then housing prices start dropping. Tom and Jane want to refinance but find that their equity is less then they thought. Also the market is not in a position to give out many loans due to the sub prime problems. The result? No loan.

That scenario is not so unusual nowadays. Countrywide, one of the largest provider of home loans, has publicly warned about this scenario. In their words “They expect people with good credit to have trouble paying their loans.” That is huge. For someone like countrywide to state this is worrisome. Why? Well, if you have people who look good on paper having problems that has large ramifications. The first is will they default? Odds are they won’t default in most cases. What will happen though might be worse. They will cut back on spending. Consumer spending has helped float the economy for years when nothing else was. We can see the problems this Christmas season according to retailers.

Now if they do default on their loan then the lender is in a bad position. Due to the lower value of the home vs. the loan there is a good chance they will not recover the loss. This increase in debt can’t be sold like it once was. This will mirror what is happening in the sub prime market now but on an even larger scale. While this will happen to some degree, no one really knows how much yet. What they do know is that we will be feeling these kinds of effects until 2009-10.

There are other effects that are coming into play now as well. I’ll go over those in the next, and final part detailing The Economic Roller Coaster.

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