Back in March I wrote:
That there will be fall out from the coming mortgage problems is a certainty. The sub-prime industry has been rife with fraud and excess, much like the S&L crisis more than 20 years ago. So too will the prime mortgage industry take some shots as adjustable rate mortgages reset upwards and cause a blip in the default rate.
But the pool of people falling behind on their house payments is starting to widen beyond this initial group, and adjustable-rate mortgages are the main reason. Starting in the spring of 2005, these mortgages began to get a lot more popular, largely because many buyers couldn’t afford to buy the house they wanted with a regular mortgage.
They turned instead to a mortgage that had an artificially low interest rate for an initial period, before resetting to a higher rate. When the higher rate kicks in, the monthly mortgage bill typically jumps by hundreds of dollars. The initial period often lasted two years, and two plus 2005 equals right about now.
I feel badly for home owners suckered into these mortgages, not savvy enough to understand the implications and pushed by mortgage brokers into a possibly unhappy future. Sure, some of those buyers wanted more house than they could afford and took the risky route but not all. Some were just plain, old fashioned suckered by a complex financial instrument.
And then there are the others; the Wall Street titans like Bear Sterns who also started to believe the lie thanks to Collateralized Debt Obligations (CDOs) which bundle up the assets and sell the slices off in tranches. That the people who value these bundles have little to no visibility on what is actually in them or that the models are so complex that errors are commonly found months later didn’t faze these companies and funds. Bear and others dove right in and made huge fees. Now they’re feeling the pain of their hubris. I have no sympathy for the Devil. They created the market and its growth in the past 6 years has been absolutely incredible.
What happens next is the spiral, the self-fufilling domino effect where credit tightens and no more cheap money begins to spread the hurt. Essentially, lenders become more cautious and the spread (how much more a borrower with a riskier investment must pay to borrow over a safe investment) increases. It’s already hit the raging private equity world where record-setting deals have seemingly come every week. The big shops, KKR, Blackstone, Cerberus, they feed off of the ability to borrow money cheaply as does everyone who uses leverage to great effect. The slowdown is already occuring.
But while the mortgage woes continue, commodity prices like oil and copper and corn continue to rise. What’s a Fed to do? Inflationary pressures abound in the commodity markets and metals should continue their rise through the end of the year. But the housing spiral is already spreading like wildfire and tightening credit markets signal a slowdown that hits not just the housing markets but all of corporate America.
The big question is will Bernake lower rates even in the face of rising commodity prices. I’d bet the housing market is too big to ignore, that as the credit crunch spreads and lower asset prices and higher commodity prices hit the average joe and force a slowdown in consumer spending, a drop in rates will be needed.
Bottom line: this ain’t over by a long shot. Housing woes will continue until Bernake signals the end with a rate cut. They’ll wait awhile before pulling the trigger and I’d bet on sometime in 2008. In the meantime, going to be a rough Fall for all those home owners and for all those CDO packagers and purchasers.