The Subprime Meltdown

The subprime meltdown is on everyone's mind right now. I was reminded of it this afternoon when a real estate agent stuck a flyer in my hand advertising a condo that has been on the market for three months, its listing price having just been reduced for the second time. Didn't we learn something from the dot-com bubble? Anyway, let's take a look back on how all this subprime mess happened, and what I hope doesn't happen in the future.

How the trouble started

When the dot-com bubble burst, people started moving their money from stocks to real estate. Something they could see and touch seemed so much safer than stock in companies like Enron that were built on creative accounting tricks. When the Fed started cutting interest rates to stimulate the economy, mortgage rates dropped as well, further stimulating housing demand. Then when people saw how fast house prices were climbing, everyone jumped on the bandwagon, causing prices to skyrocket.

Subprime loans to the rescue

With housing demand so high but prices out of the reach of many people, there was a need for affordable mortgages. This is when subprime loans came into the picture. A subprime loan is one with a high risk of default, because the amount borrowed is more than what's justified by the borrower's income and credit score. Having a certain number of subprime loans out there is a good thing, because they make the dream of home ownership possible for people who otherwise couldn't have it. But you know what they say about too much of a good thing.

It became standard practice for mortgage lenders to sell people on so-called "teaser loans." These are interest-only or adjustable mortgages that require relatively low payments for the first few years, but then higher payments later when the borrower has to start paying down principal or the rate starts adjusting upward. They reasoned that if the borrower could handle the payments in the teaser years, then when the payments rose they just had to refinance to get another teaser period or borrow more money against their rising equity.

All good things must end

I happen to be a fan of interest-only and adjustable mortgages, but only as a way of saving money on a house you can afford anyway. Ideally, you don't want to take out a mortgage that's more than double your annual income, but when you decide on a house, you might as well get a mortgage that's likely to save you money. But buying a house that you can only afford if rates remain near historic lows and your equity keeps growing is obviously a recipe for disaster.

Well, maybe it wasn't that obvious to everyone. Just like the dot-com bubble, many people got too caught up in it, and forgot that all good things must end. When rates started coming back into the normal range and prices stopped rising, people found their mortgages to be much less affordable than they once were. Many borrowers found themselves in a very stressful situation, and some defaulted on their mortgages and lost their homes. Investors started dumping mortgage-backed securities, and the subprime crisis started spreading to other areas of the economy.

So what now?

The Fed has continued with rate cuts to stimulate the economy, but doing so is further weakening the dollar, which has already lost a lot of ground against most other currencies. If this keeps up, we could be heading towards very high inflation. On the other hand, without the rate cuts, there would be a higher chance of entering a recession. Warren Buffett has said that the subprime crisis is far from over, and could affect consumers for another two years.

The one thing I'm really hoping is that we don't see a government bailout. While you may feel sorry for the people who have lost their homes and the lenders who took a chance on them, keep in mind that any kind of bailout will come at the expense of the people who were responsible enough not to bite off more than they could chew (or help others do so). The "victims" knew what they were getting into, and brought it on themselves. When I first heard about the proposal for the September 11th Victim's Compensation Fund, I couldn't believe they were reducing benefits for the people who were prudent enough to buy life insurance, and a subprime bailout would be the same thing. If you show people that there are no consequences to reckless behavior, how can you expect them to learn?