The Los Angeles Times carries an article about the “credit crunch,” caused by defaults on subprime mortgages. These are loans that are infeasible to pay off; they were made on an assurance that the “homeowner” would be able to refinance later with more reasonable terms.
But we’ve definitely entered the scary zone of the unknown: How many of your neighbors won’t be able to make their mortgage payments in the next year? How many more hedge funds worldwide will fail because of losses on dicey debt? As those numbers rise, how great is the potential for a domino effect — in other words, “My mortgage borrowers can’t pay me, so I can’t pay you.”
Alternet carried an article that suggests a financial collapse on the order of the Great Depression may be in the offing. It compares the collapse of the subprime lending markets to the junk bond scandals of the 1980s:
While Milken’s house of cards was built on leveraged buyouts (LBOs), where an acquirer issued a bond to pay for an acquisition that he would pay back with funds yet to be earned, the engine that made subprime’s train roll off the tracks are collateralized debt obligations (CDOs), which are intricately structured and packaged strategies pooled together to decrease the risk generated by the fact that they are usually home equity, car and credit loans so poorly rated that they promise only collapse for those who get them and seized assets for those who offer them.
The Alternet article projects consequences beyond the housing sector across the financial system.
The Los Angeles Times writes in reaction to recent drops in the stock market:
[The Federal Reserve] might hint that the markets are overreacting. There are technical reasons to support such a view.
Case in point: Many of the hedge funds and other big investors that bought sub-prime mortgage bonds did so with borrowed money, to juice their returns. Now that the bonds have collapsed in value, the brokerages and banks that lent investors the money are calling in their loans.
That, in turn, is forcing some investors to sell their bonds even though they may believe the prices of the securities are ridiculously low because of the panicked environment.
If these investors could hold on to their bonds, they might be OK. But their lenders aren’t interested in waiting this out with them.
As bonds are dumped at fire-sale prices, the effect is to depress the value of similar securities across the board. More investors find their lenders calling in their credit lines. It’s the most vicious of circles.
The same thing is happening in the stock market. Investors have borrowed record sums against their brokerage accounts over the last year. That “margin debt” at New York Stock Exchange member brokerages hit an all-time high of $378.2 billion in June, up 67% in 12 months, NYSE data show.
As stock prices slide, brokerages demand that margin borrowers put up more collateral to back the loans. The easy way out is to sell securities and pay down the debt. That selling is accounting for some unknown, but no doubt significant, share of what has happened in the stock market the last two weeks.
Excuse me, but exactly what technical reasons are we seeing here for thinking the markets are over-reacting? While I can’t assess the scale, this sounds a lot like the scenario described in my history classes as leading to the Great Depression. It sounds a lot like, as the article puts it, “the most vicious of circles.”