(not Charlton related)
With Charlton at severe risk of becoming a 'subprime' football club (sub-Premiership to be precise), it's appropriate perhaps that the US media is finally waking up to the '
subprime lending scandal' that is beginning to unravel. Barring something unforeseen, it is likely to lead to tens of billions of dollars of bad loan write-offs, and the enforced homelessness of hundreds of thousands of families.
The scandal can trace its roots back to the beginning of the US housing bubble which began (not coincidentally) after the collapse of the technology-fuelled equity market in 2000. The Federal Reserve subsequently cut interest rates to 1% in order to avoid a Japanese-style deflation, thus providing the fuel that replaced an equity bubble with a housing one. Having risen at 2.9% pa for the 1990-1999 period, prices rose at 9.3% pa from 2000-2005.
The rapid rises in house prices (most vivid in hotspots such as Florida, California and Arizona) were a boon to anyone who owned a home, but they were particularly welcomed by low-income families previously shut out from the mortgage market. So long as prices kept rising, low-income families were able to borrow from specialised unregulated lenders such as New Century (see
recent news) at low initial 2 or 3-year 'teaser rates', safe in the knowledge that when the subsequent 'payment shock' occurred, they would easily be able to refinance into a new loan (thanks to the equity they had built up). What's more, as the cartoon shows, some of that equity could be turned into cash and added to the principal of the new loan.
Whilst low interest rates were a boost to homeowners (and anyone owning risky assets, including equities again), they were most unwelcome to those lenders that rely upon yield to fund liability obligations, from insurance companies to pension funds. They were also a bore to foreign governments from Riyadh to Beijing, who needed to recycle income from imports back into US dollars to prevent their currencies from appreciating against the greenback. I discussed this phenomenon in more detail in my Dec 2006 post on
Petrodollars.
Wall Street firms are rarely slow to spot a profitable opportunity, and the context described above encouraged them to aggressively promote new complex financial products (known variously as 'securitisations' and 'collateralised debt obligations') that would marry the homeowning dreams of the subprime borrowers with the yield-hunting needs of the cash-rich.
The initial 'teaser rate' described above was still higher than the interest rate charged on mortgages sold to so-called 'prime borrowers' (steady jobs, no history of default etc..). Hence billions of dollars of subprime mortgages could be originated (increasingly with ridiculously weak lending standards), and then sold on via the banks through the above securitisation process (essentially describes the repackaging of pools of loans into several 'tranches' with varying risks and returns). Because the ultimate liability in the event that these mortgages became non-performing was passed on to a third party, there was no incentive to stop lending, and so it continued.
Whilst house prices were rising, not only was the higher interest rate attractive to those seeking yield, but defaults were low because only the most desperate homeowner will hand the keys back if they have built up some equity. Hence it really did seem to be a 'free lunch' (higher yield for no additional risk) and hence the party continued, and the lenders created ever more complex products to entice the most vulnerable borrowers into buying their first home. A particular favourite of mine was the
negative amortisation loan, in which a borrower could opt out even of paying the interest due each month, with unpaid amounts simply added to the principal. In 2004 and 2005 alone, nearly $1trillion worth of subprime mortgages were originated, representing some 10% of the entire US mortgage market.
In November 2005, something rather important happened; house prices stopped rising. Although the housing bubble had never truly been a nationwide phenomenon (the Midwest and Texas for example never joined the party), prices began to fall hardest in those very areas where subprime borrowing had been the greatest. However there was inevitably going to be a delay between the fall in house prices and homeowner defaults, because rolling annual house price growth did not turn negative until well into 2006. It was only those unlucky enough to have bought right at the very peak that would not have enjoyed any appreciation.
Inevitably, as the wave of newspaper headlines declaring the end of the bubble spread across the nation, those homeowners whose timing had been the least fortuitous did exactly what one would expect from a segment of the population that quite frankly should never have been permitted to borrow money; they simply stopped paying. After all, it was not as if they had a credit rating to protect. Indeed as one commentator put it, "...most of these people had credit ratings equivalent to the one they give you upon leaving prison."
Some of the earliest implications of this lending extravaganza ironically
surfaced in the UK when that bastion of cool-headedness HSBC, was forced to admit it would take a $1.8bn hit for bad loans issued by its subprime subsidiary HSBC Finance (formerly Household International). And closer to home far less scrupulous lenders than HSBC began to admit to the scale of the problem, with the outright closure of some entities (Ownit, Sebring) and the collapse in the valuations of the likes of the aforementioned New Century. These lenders rely upon so-called 'warehousing' to finance loans between the date they are originated and the date they are securitised (ie. sold on). As their problems came to light, the warehouse financing option was simply removed and their business models collapsed. Even the world's bulge-bracket banks are
under scrutiny by investors as they scramble to unravel where the exposure to this lending spree really lies.
Estimates of the eventual losses to be sustained vary. Currently approximately 13% of all subprime loans are 'delinquent' (at least 60 days behind with payments) and in the absence of a sudden rebound in house prices, it is reasonable to expect the vast majority to proceed to outright default and foreclosure as the date of the 2 or 3-year 'payment shock' looms. Assuming a total subprime market of $1trillion, and assuming approximately 65% recovery (the firesale proceeds when the lenders reclaim the properties), then it is likely that total losses will be at least $85billion. This is six times greater than the profits earned in 2006 by perhaps the world's premier investment bank, Goldman Sachs and is likely to be the first genuine test for the world's financial system since the Russian default and LTCM crisis of 1998. Meanwhile the number of families likely to be turfed out of homes that they should never have been permitted to buy in the first place, might reasonably be estimated to be at least 500,000 (assuming an average property value of $250,000).
The ultimate responsibility for the subprime scandal lies in several places, but it ought to be seen in the context of the same global liquidity explosion that helps to explain everything from the extreme values of modern art and high-end real estate, to the fundamental undervaluation of the Japanese Yen. At some level, the homeowners themselves ought to have remembered the concept of
'caveat emptor' ('buyer beware') since many seem to have done less research into their home purchase, than they did for the furniture and appliances that went into it.
The concern however is that it seems that no-one ultimately seems to know where the financial buck actually stops. Who is on the hook for $85billion? The regulators will hope the risk is sufficiently diversified to ensure the damage is restricted to 'wounding by a thousand cuts' rather than likely to cause to a localised blow-up. Few of us will lose sleep if governments in Asia and the Middle East take the brunt of the losses, but you can also rest assured that there are millions of pensioners and insurance policy holders worldwide (including the UK) blissfully unaware that their 'fiduciaries' saw fit to invest in subprime mortgages.
And when the losses have been digested, lessons learned and some fraudulent practioners are doing porridge, the next wave of business school undergraduates will learn about the wonders of securitisation and the damage it caused, before they are let loose on the same global banks that invented it in the first place. And perhaps the brighest in the class will be able to explain how on earth a pool of low-grade subprime mortgages issued to homeowners with no money down and no proof of income could, thanks to Wall St wizardry, be sliced and diced such that fully 75-80% of it was awarded bullet-proof AAA credit ratings, when infact the underlying creditworthiness was, in short, absolute crap.
As I correctly predicted yesterday, an edgy affair would be sealed 1-0 by a Darren Bent goal. The transformation in our fortunes under Pards has been remarkable with virtually the same squad of players that his predecessors 'enjoyed', and arguably with worse injuries. If you strip out the Arsenal/Man Utd/Chelsea fixtures, we have taken 18 points from the other 9 'winnable' games under Pards, and have been beaten only once (by 'Boro). 
