This is probably the umpteenth article I’ve written about the subprime lending mess and for some reason, I still find something else to say about it. It seems that nary a day goes by without some mention of the doom and gloom hitting the property market.
In the past, I covered the causes of this crisis at the personal level with stories from people who’ve lost out. This time, I wanted to cover the causes at the macro level as well as the subsequent fall out from this situation.
Let’s start with this question: Do any of these people look familiar?
- You have debt and want to borrow money.
- You are a house bubble sitter, one who’s waiting for the chance to buy at lower home price levels.
- You need to refinance your mortgage.
- You are an investor in the stock market.
- You are an investor in the real estate market.
- You are a homeowner.
If you see yourself in any of these people, you’re in good company. It looks like we’ve all taken a hit by subprime lending gone sour. Whether we like it or not, current real estate woes are actually affecting the lot of us more than any of us realize.
To understand the effects of the bust, let’s see how this supposed “financial contagion” has transpired. It’s all cyclical you see, since it starts right after the last bubble bursting episode in March 2000.
How The Housing Boom Unraveled
In short, this is what happened: the 2000 dot com bust led to a mild recession which subsequently led the Federal Reserve to cut rates low enough. These actions triggered borrowing and cheap money to fuel asset inflation and housing prices eventually heated up. After many years of this, the usual complacency and desire to keep the bubble going caused folks in the lending industry to resort to exotic loans and riskier practices. Credit got looser, enticing less qualified people to become heavily leveraged homeowners.
I remember how a few of my friends happily overextended themselves to own their half million-to-million dollar homes by cobbling together several loans to make it work. Things worked out for them since their homes are now valued at 50% higher than what they originally bought them for, so they’ve been rewarded for taking the risk. They were the lucky ones even as the financial climate changed and the central bank reversed its course by raising rates. Those less lucky who were carrying risky loans started to feel the squeeze, causing them to default on their mortgages and eventually foreclose.
Without expert photoshop skills to aid me, here’s my attempt at describing how the ugliness transpired:
risky loan products got eliminated —> hedge funds were hit (as they held suddenly cheaper mortgage-backed securities) —> home sales declined —> people panicked and at the end of it all —> the stock market did tank (though it has bounced back since, in reaction to the last rate cut).
This is yet another cycle of boom to bust. With history repeating itself, it shouldn’t be a massive surprise. In fact, it’s said to be a good thing for its financial health restorative effects.
So what’s next for us? We’ve got to live with some changes now. And they appear to be across the board.
The Consequences of The Subprime Collapse
Credit got tighter.
With interest rates higher, money just got more expensive to borrow. There are also tighter restrictions for getting loans: you need a higher down payment to qualify for a loan plus you need to have very good credit to get a good mortgage deal these days. A friend of mine who is a real estate investor is not thrilled by these developments at all. He tells me stories of people with perfect credit who are now at the brink of foreclosure due to tighter rules or unlucky circumstance. These people have “upside-down” homes that are now cheaper than their purchase price and are therefore unable to find refinancing for their adjustable rate mortgages due to stricter refinancing terms. Since they are unable to refinance, they become stuck with existing mortgage payments that simply grow larger with interest rate hikes. When payments become prohibitive, they are forced to default.
Buying a house got tougher.
If you’re a house bubble sitter happy to wait for lower priced homes, you may be less excited about today’s cheaper housing market. That’s because borrowing to buy a house is now under greater scrutiny. With credit drying up, all those fancy, exotic loans that allowed just about anyone to attain a new house disappeared with a whiff. “Stated-income” loans allowed borrowers to declare but not submit documentation of their income in order to qualify for these loans. These loans used to make it easier to borrow but they are now extinct. There are stricter requirements for purchasing a house today: higher interest rates on jumbo and non-conforming loans (greater than $417,000), better credit scores required, down payments of 10% or more to snag the best loan rates.
Selling a house got much harder.
For sure, you don’t want to sell your house now if you can help it. Have you checked out the comps in your neighborhood to see what kind of hit your house’s value has taken and what kind of discount you’ll be shaving off your home today? There’s more to this cycle to ride out.
The stock market got scarier.
We all know how much this market sucks. I hope you’re keeping your powder dry to buy in on the dips. I’d expect this downturn to work itself out over a period of several months. If this is a summer cyclical swoon, then come November, there could be a recovery. But don’t count on my predictions…. I don’t have a crystal ball. If you’re well diversified and have a long term view, you need not be too concerned.
Subprime Is The New Ugly But It’ll Get Better
So it looks like we’re all sharing in the pain here. Each one of us alike — debtor, buyer, seller, investor — have lighter pockets than we used to have. We’ll need to see how long this drama plays out. In the meantime, check out the following articles I’ve written to share my own thoughts about how to ride these bucking markets without feeling too dizzy:
If The Stock Market Makes You Nervous, Keep Things In Perspective
Shrug Off A Stock Market Slide! Some Surefire Ways To Survive A Market Fall
5 Ways To Survive A Volatile Stock Market
Hang on tight!
Image Credit: Truth Dig
Silicon Valley Blogger,
Good post. Your last section reminded me of the sage advice from the Hitchhiker’s Guide: “Don’t Panic.”
You mentioned homeowners running into stricter refinancing terms. Unfortunately, it seems that the secondary mortgage market can get a bit reactionary at times in coming up with these restrictions. Recently, I ran into a new one–lenders declining refinance loans to homeowners who have attempted (unsuccessfully) to sell their homes in the last 12 months. Unfortunately, some more bad news for homeowners, but also a word of caution to those who don’t yet find themselves in this situation. (I’m putting a post up on this shortly.)
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Look, you’ve gotta stop writing about things you don’t have a clue about. You’re going to get alot of people hurt. At least do your homework. Outside of generalities you’ve shown no evidence that you can even define ’subprime’ in a meaningful way.
You are in the bottom of the first as far as this credit problem goes. I am one to know having written over 1 billion of the loans you purport to understand. The deck is stacked against the debt-market until well beyond 2011. The extremely sharp rises in the CPI indexes should be cluing you in about now but you aren’t really watching. Like most ‘journalists’ nowdays you are more inflated with hot air than the phenomenon you attempt to describe.
This is no normal bubble. This is so unlike the correction of 2000 that it likens your attempted analogy to that of a kindergarten child sticking square blocks in round holes. Other than gross mechanics there is NO SIMILAIRITY. The Dot-com correction is a historical footnote to this credit contraction: the actual historical event. It will be difficult to begin your introductory course here but here I will try for what it is worth.
The global financial system is predicated on legal tender than derives its value from faith in data integrity and faith in data analysis: both have been lost almost completely. Is it so difficult to understand that value of intangibles will also plummet? Or that there will be a corresponding sky-rocketting in the evaluation of tangibles? Wake up! This is catastrophe.
You should be advising people to get real and to go long on things that are real instead of consoling the frog in the boiling water to stay the course and be brave. You are the shepherd of death Mr. Digital and you will reap the blind stupidity you sow along with all those who follow your blind lead.
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Mike,
I’ll be looking for your post on this.
As for John Locke, I’d appreciate if you give some concrete recommendations as to how to deal with this catastrophe, then I’ll give you the floor to gnash your teeth and wring your hands like so many other chicken littles out there. Yes, I’m aware of the huge risks we face today due to subprime. But I’ve also written how so far things are isolated and unless this thing winds its way through all other parts of the economy, the pain is isolated.
Best way to approach things right now is to keep some powder dry, strike when things are at its cheapest (buy at low points, be a contrarian), be well-diversified (with what you have, stay the course or rebalance your assets accordingly) and not be overextended with credit. This way, you’ll weather the “ugly” of the subprime upheaval.
So John — let me hear what you have to suggest to our readers here. Do we all hide our money under the mattress or put everything in gold?
Yes, I second Silicon Valley Blogger and would also like to hear something concrete from John Locke. Do you recommend selling all our stocks and putting all our money in FDIC insured accounts, treasuries and maybe gold? Is that what you are doing? Since most of us aren’t in a loan business, could you also talk in plain English?
Forget about internet bubble, I am curious how you compare today with the 90s. As I remember - and I actually lived through it - the prices started going down in late 80s, went down for many years until they started to slowly go up in late 90s. It took over a decade for the real estate prices to reach 80s levels. When I was “upgrading” in mid-90s, a family who sold me their townhouse had to add money to pay off their mortgage. It hasn’t been nearly as long yet, nor have the prices dropped nearly as low yet, at least not around here (Westchester county, NY). Around here the prices are still several times higher than in the 90s, I cannot talk about other areas. Do you think we’ll drop back to the 90s levels?
To be honest, this could turn out to be a rough housing market cycle that could last as long as 6 or 7 years. It could also end up shorter than that. If you aren’t buying or selling, I’m not sure how much this would affect you, as a long term property owner. We’ll see how it plays out though. I’ve sat through many stock market cycles and property cycles so I’m wondering how different it will be this time, as per John Locke.
Sillicon Valley Blogger, it wouldn’t really affect me personally, except for when I perceive the “bottom”, I might consider investing or repeating “upgrade at the bottom/rent out old place/sell for more” thing that worked for me in the 90s (easiest money I’ve ever made) or just investing part of 401K in REIT. I’d probably wait until there are some signs of recovery.
Then there is also stock market… Nobody wants to loose money. With all the predicted gloom and doom, maybe we’ll see next Great Depression. Just kidding.
I do believe we are a few years far from the bottom, but I was curious what our “expert” here thought. I don’t remember the reasons for the 90s downturn, by the way, does anybody?
Of course if we all could predict the future, we’d all be rich.
[...] mess, and I never link to anything about it, I did enjoy The Digerati Life’s article on the causes and consequences of the subprime crisis. There, that’s probably the only link I’ll give about [...]
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Dear SVB, The content and title don’t really match here! If you want to find the root cause of our subprime mess you first have to ask, how is it that we have a large subprime market in the first place? Where was it in the ’70s and ’80s? Why is it blowing up now? The answer is: Bill Clinton’s Cummunity Reinvestment Act. In the 90s, the Clinton Administration began suing, harrassing, and coercing banks to lend money to bad credit risks as a way to offer homeownership to anyone in America. It worked essentially like credit quotas and forced banks to take “subprime” risks and then figure out ways to unload that risk. Like similar attempts to interfere in markets, it was popular politically but bound to end up a disaster. (If you think this looks bad, wait until we apply similar logic to health-care!)
The housing bubble is a different matter. What we now have is the 2 issues colliding and that makes it look worse than either is alone. The bubble was bound to burst (everyone knew that) and the subprime market will re-price and amount to a bad day on wall street when all is said and done. The good news here is that those who can no longer afford their mortgages will lose very little since they had no equity in the first place! In fact, I could see many mortgages converting to leases and allowing the tennant to stay under new terms. Let’s hope…
Ronny
The personal effects of sub-prime is what bothers me. Social Mobility and the American dream are at threat. There will be no more flipping and less avenues for the lower middle class and working class to better themselves. Credit will become tight and a recession will lead to a reduction in jobs. The consequences of the subprime collapse are marked.
[...] been following the subprime mortgage debacle for a while now, giving it a lot of coverage. This bust has left us with some tragic results, as homeowners far and wide are left [...]
[...] Posted by Source In short, this is what happened: the 2000 dot com bust led to a mild recession which subsequently [...]
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I agree with John Locke comments.