Tuesday, October 9, 2007 started as a nice day in New York City. A lovely early fall day, with
the temperature still a balmy 80° at 2:00 in the morning. By evening,
though, the temperature had dropped twenty degrees, the clouds had rolled in,
there was thunder and rain.
As with the weather, there were some hints of trouble here and there
on Wall Street. But all in all, things could not have seemed better. Little
did we know, the stormy end of 10/9/07 signaled a
very large bubble that had just popped.
That was the day when the Dow Jones Industrial Average hit its
historic peak. From there, it was all downhill -- slowly but steadily at
first, and then violently after last August -- until the Dow bottomed (for
now) on March 9 of this year. Over that span, the index lost 54% of its
value.
It’s been a crushing blow to just about everyone. But it’s
already being referred to as the
crash. As if the unpleasantness were now all behind
us. More likely, in the future it will be seen as, simply, the first crash.
Don’t believe it? In a moment you will, when you see the
scariest graph of the year.
But let’s quickly recall what’s already happened. During
the late, great housing boom, interest rates were at microscopic levels,
while bankers were encouraged to grant home loans on little more than a wink
and a nudge. In order to inflate their balance sheets, those bankers resorted
to all sorts of gimmicky, adjustable rate mortgages (ARMs),
whose common feature was an interest rate that would eventually reset. That
is, it would balloon somewhere down the road. And those most likely to come
quickly to grief were the riskiest borrowers, who held loans known as
“subprime.”
“But not to worry,” borrowers were told. “Betting on
ever-rising home prices is the safest wager in the whole wide world. If you
have problems with cash flow when the ARM resets, your house will be worth a
lot more, so you can simply sell it and walk away with a nice chunk of change
in your pocket.” Uh-huh.
The bankers themselves were a little more concerned about the
deterioration of their portfolios. They took out insurance in the form of
credit default swaps (CDSs). These were a brand-new
invention in world financial history, allowing mortgages to be sold and
resold until they were leveraged 20 times over. They became the shakiest part
of a huge global derivatives market, with a nominal value in the tens of
trillions of dollars.
For a while, this Ponzi scheme even worked.
But then, as they had to, the ARMs began resetting,
and there were defaults. Then more of them. Because at the same time, the
housing market was cooling off and the economy was stalling out. More and
more people were trapped in a situation where they owed more on their home
than they could sell it for. Many simply mailed their keys to the bank and
moved on.
All of this wreaked havoc in the derivatives market. Sellers of these
exotic packages could no longer establish what they were worth. Buyers
couldn’t determine a fair price and so stopped buying. As the ripples
spread through the world financial system, trust disappeared and liquidity
dried up.
Now consider that the base cause for all that dislocation was the
subprime sector. And how big is that? Not very. Subprime mortgages account
for only about 15% of all home loans. Their influence has been way out of
proportion to their numbers, because of derivatives. Here’s the good
news: the subprime meltdown has about run its course. These loans were
resetting en masse in 2007 and the first eight months of ’08. Now
they’re pretty much done.
And the bad news? No one in the mainstream media seems to be asking
what should be a pretty obvious question: What about loans other than subprime? Truth is, the banks didn’t just trick up their subprime
loans. ARMs were the order of the day –
across the board.
Now, here’s that frightening graph we referred to earlier.
Take a good, long look. You can see that from the beginning of 2007
through September of 2008, subprime loans (the gray bars above) were
resetting like crazy. Those are the ones people were walking away from,
sending a shockwave from defaults and foreclosures smack into the middle of
the economy. Now they’re gone.
The ARM market got very quiet between December 2008 and March 2009,
hitting a low that won’t be seen again until November of 2011. Small
wonder a few “green shoots” have poked their heads above ground.
But in April, resets began to increase and will reach an intermediate peak in
June. After that, they tail off a little, going basically flat for the next
ten months.
It’s not until May of 2010 that the next wave really hits. From
there to October of 2011, the resets will be coming fast and furious.
That’s 18 months of further turmoil in the housing market, and the
beginning is still nearly a year away! (Although the months in between are
likely to be no picnic, either.)
While it isn’t subprime ARMs that are
resetting this time, neither are they prime loans. Those eligible for prime
loans wisely tended to stay away from ARMs in the
first place, as indicated by the relatively small space they take up on each
bar.
No, the next to go are Alt-A’s (the white bars), Option ARMs (green) and Unsecuritized ARMs (blue). Alt-A’s are loans to the folks who are
a small step up from subprime. Unsecuritized loans
are a 50-50 proposition; either the borrowers were good enough that they
weren’t thrown into the CDS pool, or they were so risky no one would
insure them.
Those two are bad enough. But Option ARMs
are the real black sheep, loans with choices on how large a payment the
borrower will make. The options include interest-only
or, worse, a minimum payment that is less
than interest-only, leading to “negative
amortization”—a loan balance that continually gets bigger, not
smaller. Imagine what happens with those when the piper calls.
Once the carnage begins, will it be as bad as the subprime crisis?
That’s the $64K question. Perhaps not. For one thing, subprime loans
were a much larger chunk of the market when they started going south. For
another, there’s been a lot of refinancing as interest rates dropped;
that should help ease the default rate. And the government has massively
intervened, with measures designed to prop up those who would otherwise lose
their homes.
On the other hand, we’re in a severe recession, which
wasn’t the case when the subprime crisis started. More people will be
unable to meet payments. And the housing market has continued to decline,
pressuring both marginal homeowners and banks that can’t sell
foreclosed properties.
Is the stock market’s next 10/9/07 on the way? Yes. Which day
will it be? That’s unknowable. It could be in a week, or not for
another year.
But make no mistake about it, the second crash is coming. It can’t be prevented, no matter what desperate
measures Obama and his hapless financial advisors come up with. All we can
hope for is that, with a little luck, it won’t be as severe as the
first one. But it will last longer. We aren’t even in the middle of the
woods yet, much less on the way out.
The order of the day is to be very defensive. There will be few safe
havens, but they do exist. Read our report on “48 Karat Gold,” a
gold-related, conservative investment that has continued going up even while the common stock market bombed. It’s not too
late to profit… click here to learn more.
Doug Hornig
www.caseyresearch.com
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