Friday :: Mar 16, 2007

Subprime Market Foretells Future Recession

by Mary

Back in 2004, Alan Greenspan thought that people would do well in converting their housing equity into new spending and that more flexible loan packages could allow more people to get into the housing market than before. As he said:

American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.

So the lenders created lots of new loan packages that would allow people to free up their equity or to buy their dream home. The only problem is most of these loan packages were really licenses to steal from the poor and most vulnerable.

The smart money was that no matter how risky these loans would be for the individuals taking these loans, the overall risk to the economy would be manageable.

Pros Go Unscathed
Why are hedge funds willing to buy risky loans directly? Because they can demand terms that help insulate them from losses. And banks, knowing what the hedge funds want in advance, simply take it out of the hides of borrowers, many of whom qualify for lower rates based on their credit histories. "Even if the loan goes bad, [the hedge funds are] still making money hand over fist," says Engel.

Eventually, some of it will go sour. But the Wall Street pros who buy option ARMs are in the business of managing risk, and no one expects widespread losses. They've taken on billons in iffy option ARMs, but the loans are no shakier than the billions in emerging market debt or derivatives they buy and sell all the time. Blowups are factored into the investing decision.

Yet, as Nouriel Roubini noted back last year, the loan packages that were been marketed so aggressively to the "subprime" market, were also underpinning a significant number of loans in the "prime" market. And failure of the housing market is rippling though the US economy much as Roubini predicted last year when the consensus was that the housing market would continue strongly.

Today he has a post up about the pretty stories economists are saying about why the failure of the subprime market isn't such a big deal. This "bubble" created out of the belief that you can make lots of money off the vulnerable and poor, is going to come back and bite the US economy big time.

Mary :: 9:54 AM :: Comments (7) :: Digg It!