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Mark's Market Blog

12-12-08: Sub-Primes and Bailouts

By Mark Lawrence

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Well, it's been an exciting but uninformative week. Everyone on Wall Street held their breath to see if the government would actually bail out GM. The market spent the week basically flat overall. Turns out, as of today, the answer is no, there will be no GM bailout this year. The Democrats realized a couple weeks ago that they could not get a palatable deal from senate Republicans, so this time they tried negotiating directly with Bush. They made their deal, and the House passed it. In the Senate, the Republicans ignored Bush and held out for guarantees of UAW wage cuts and debt-for-equity swaps, saying that without these Detroit would never be competitive with Japan. Perhaps this is even true. In any case, no bailout. Now Bush says maybe he'll do a minor bailout from the Treasury's $700 bailout money, enough to keep Detroit alive for a month, and leave the heavy lifting for the next congress.

Technical analysis of the market has been showing for about a week that Monday the 15th was a breakout day - a day when the established trends would be left behind and the market would move in a new direction. Today it's looking like not only is this true, but the new direction will be back down, breaking through the newly established support level of 850 S&P.

It's worth while to ask how this all happened, especially as I for one was taken totally by surprise by the October crash. This all started with home loans. Until about 2003, banks took loan applications, evaluated the people, and decided if they wanted to loan the money. However, from about 2000 until 2007 there was a steadily growing trend, loan securitization. Banks would bundle up a few dozen mortgages and sell them off to an investment bank (you know, those recently extinct dinosaurs like AIG, Bear Sterns, Lehman). The investment banks would bundle up dozens of these packages, and sell bonds with a couple thousand mortgages as collateral. Historically about 1%-2% of mortgages go bad, so these sold like hotcakes to people looking for good gains and low risk. They sold so well that the investment banks started offering higher and higher prices to banks; banks paid huge rewards to employees to find them mortgages; and the employees did whatever was required to find the mortgages. There was recently a story of a high school dropout who made $2.5M in bonuses in two years collecting mortgages from brokers for her bank. She relates that by 2005 brokers were demanding sex in addition to kickbacks.

Today we know that when mortgages are handled wholesale like this instead of retail, the foreclosure rate goes way up. In 2001 sub-prime mortgages were about 4% of the total. By 2006 sub-primes were 44% of the total, and most of these were "liars loans," mortgages where income and assets were never verified. It turned out that the risk on these bonds was ten to thirty times higher than was assumed.

Paul Volcker, head of the newly created Economic Recovery Advisory Board, feels that these changes in the financial system have eclipsed government regulators, allowing excesses to go unchecked and subjecting the economy to ever greater shocks. "Simply stated, the bright new financial system failed the test of the marketplace." said Volcker. Princeton University economist Alan Blinder said "Paul has some old-fashioned ideas that banks should apply some common sense to loaning money -- like making sure borrowers can repay."

In early 2008 the government started aggressively modifying loans with the hope of preventing many foreclosures. Unfortunately, 53% of borrowers with loans modified in the first three months of 2008 and 51% of those with loans modified in the second quarter could not keep up with payments within six months, according to U.S. Comptroller John Dugan, who spoke at a housing conference. The report, which will be released in full next week, covers nearly 35 million loans worth a total of $6 trillion -- or 60% of all primary mortgages in the United States.

A record 1.35 million homes are in foreclosure, while the number of borrowers who have fallen behind on their payments soared to a record 4.2 million. This is 6% of US homes. Estimates of total foreclosures in the next couple of years easily range up to 10% of all homes, and some think 25% might be more realistic.

You know that TV show, where they find a "needy" family and build them a house, free and clear? Turns out that of the houses that are over a year old, more than half of them have been foreclosed - the family would take out a mortgage on their new house, use the cash to start a business or something, and then lose it all. I'm using this as a learning point with my kids: some people really are unlucky, but most poor people just have horrible money skills. Since they watched their step father do exactly this and cost their mother her house, it hits home.

I've been talking for some time about a liquidity trap, where banks have money but are unwilling to loan it. Last week Sec.Treasury Paulson said that if banks didn't start loaning a significant portion of their bailout money, there would be serious repercussions. However, with unemployment increasing, foreclosures increasing, and the recession only deepening, it's hard to see who a bank would loan to - basically, if you need the money you're dangerous.

This month's t-bill auction was record setting: 90 day t-bills sold for .005% interest, 30 day t-bills sold for 0% interest. That's the first time this has happened, ever. Most of the t-bills sold to large institutional investors, who want to be able to say in their year-end report that they have a bunch of money safe in t-bills. These people would rather put their money out for zero interest than loan it to anyone they know.

Meanwhile, determined to stave off another great depression, the government is bailing out all banks that are "too big to fail." They missed out on this once this year - they let Lehman Bros. go bankrupt - and that immediately lead to a 25% drop in the stock market and a 10% drop in real estate prices within a month.

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