Monday, July 9, 2007

Irrational Exuberance Runs Amok

Alan Greenspan, the party-crossing Chairman of the Board of Governors of the Federal Reserve for 20 years, was very circumspect in his pronouncements, positively cryptic. As the Wall Street dot-com frenzy hit its peak in 1999, he actually ventured into straight talk. He called what was going on "irrational exuberance", as share prices of dot-coms grew higher and higher, unjustified by any existence of profits. Even dot-coms which were barely more than domain names managed to collect millions of dollars from eager investors, until the frenzy peaked and share prices collapsed.

Maybe Greenspan should have said something before that happened, but "irrational exuberance" caught on as an apt expression of a market bubble, that is, bidding up the price of something until it's all out of proportion and the next stage is a collapse of prices. Wall Street seems like a rollercoaster with each car filled with gamblers betting on the next big thing until they reach "irrational exuberance", irrational meaning "deprived of reason" and exuberance meaning "effusive and almost uninhibited enthusiasm". They're riding high and there's no end in sight. They refuse to believe despite all evidence to the contrary that reality will set in and prices without foundation will collapse.

That is what is happening in the housing market. It accelerated in value from (year) until (year), when the tipping point occurred and housing prices began their descent. It was inevitable that the housing boom would start to bust, or that the housing bubble would begin to burst (whichever metaphor you prefer). The boom was fueled by an atmosphere of low inflation and cheap, easy credit And Wall Street introduced some innovations to the previously staid practice of granting mortgages.

It used to be that you'd go to a bank for a home loan (mortgage) and the bank would determine whether you were creditworthy by assessing factors such as whether or not you were employed, whether you paid your bills on time, had a steady income and could make monthly mortgage payments. In exchange for giving you money, the bank wanted to know if it could be repaid. The quality of your creditworthiness would determine the interest rate on the mortgage. If your credit was good, you'd get a lower interest rate. If it wasn't so good, you'd get a higher interest rate. And if you were deemed a bad risk, you didn't get a mortgage, period, until you could build up your creditworthiness.

Then the lending structure changed. Wall Street smelled the opportunity to make a lot of money from so-called subprime mortgages--mortgages given to people who wouldn't normally be considered qualified buyers. Instead of banks granting mortgages, Wall Street investment firms would hire a lender who would in turn hire a mortgage broker who would grant the loans to unqualified buyers so they could become homeowners.

There were plenty of incentives to sell these loans: brokers and lenders could charge exorbitant fees (much more than with prime loans) to grant these loans and Wall Street could turn around, repackage the loan into something called a "collateralized debt obligation" and sell it to investors on the premise that even though these CDOs were based on bad credit, the interest rates were higher than junk bonds and housing prices kept going up. In turn, they wouldn't look very deeply into the creditworthiness of the borrowers. In fact, in Wall Street circles these subprime loans were known as "liar loans" because the borrowers often lied about their income. Wall Street wasn't too concerned as to whether or not the borrowers could pay them back; housing prices kept escalating so the value of their homes kept increasing. If a borrower couldn't meet his obligations, he would just borrow some more money (refinance) based on the higher equity he could extract from his home. Everything was jake until housing prices stabilized and buyers began withdrawing from the housing market because they couldn't automatically "flip" the house (resell it for more money). Sellers began outnumbering the buyers and prices went down. So did the equity in these sub-prime financed homes. Borrowers in over their heads with these subprime loans couldn't refinance and became delinquent in their mortgage payments. Foreclosures multiplied. Soon whole neighborhoods were dotted with empty, boarded-up houses, which had the effect of driving down the value of the perfectly nice borrower next door who did have a prime mortgage. So even those with good credit began being affected. The inventory of unsold existing homes increased. There are still construction contracts requiring builders to build new homes in the face of an oversupply of existing homes.

Most subprime mortgages are ARMs (adjustable rate mortages). An ARM is a mortgage with an interest rate that may change, usually in response to the Treasury Bill rate or the prime rate. The purpose of the interest rate adjustment is primarily to bring the interest rate on the mortgage in line with market rates. ARMs usually start with better rates than fixed rate mortgages in order to compensate the borrower for the added risk that future interest rate fluctuations will create. So far the subprime borrowers have been paying the lower rates; soon the mortgages will adjust and monthly mortgage rates will increase, leading to more foreclosures. And around and around it goes, the roller coaster turning into the ferris wheel, an endless loop of cause and effect with no end yet in sight.

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