THOUGHTS ON THE ECONOMY & THE SUB PRIME LENDING FIASCO

In my opinion, the real beneficiaries of Federal Reserve rate cuts are on Wall Street. This is probably short-term relief. Until recently, Traders have been too self-absorbed to realize the economic reality.

Rate cuts, by themselves, will not help liquidity if financier’s do not gain the confidence to lend money. Currently that is what’s happening worldwide. Lenders don’t know who or how much is involved in this sub prime, bond and junk financing fiasco. Central banks worldwide continue to pour billions into their economies for banks to borrow and re-lend to corporations. Yet, very little lending is actually taking place. The current rate cuts and infusion of cash may be too little-too late and should have been done months ago when the crisis first became evident.
Many big lenders have closed and locked their cash drawers for lending to each other.

Unfortunately, there is little trust when one does not know who is holding "the old maid" card.
The inability to borrow creates a lack of liquidity and financial markets rely on liquidity to function. The US and world economies are "faith based" and there’s little confidence at present. If big banks won't lend to major corporations, they are not going to lend to small businesses. Capital necessary to grow and hire employees will be unavailable, or available at terms and interest rates that are prohibitive.

The recently announced amnesty for sub prime borrowers orchestrated by President Bush and Secretary Paulson is not a bail out. It is a promise to work with some of the borrowers and help them if they qualify. Whoa, wait a minute! Do we really think 1.2 million or more sub prime borrowers will qualify to freeze low teaser mortgage rates for five years or be allowed to convert existing ARM’s to low rate 30 year fixed loans? A Wall Street Analyst recently stated the rate freeze program is voluntary and politicians (including President Bush) have greatly overestimated the generosity of Wall Street. In other words the investors have the final say. Most banks and lenders don’t have the power to extend those teaser rates because they don’t own the loans. The loans have been cut up and distributed into CDO's (collateralized debt obligations) and other securities of recent invention. They were sold to investors all over the world. These investors will expect a return on their money. Most have other channels for philanthropic ventures.

The recently announced bank super fund put together by Citi Group, Bank of America and Wells Fargo is already falling apart. These banks have such high losses in their own investment portfolios, they can't afford to set aside billions of dollars to bail out smaller banks or each other. The rats are jumping from the sinking ships and there will be more CEO's getting the axe from blue chip investment firms.

This liquidity mess was caused by greed and stupidity and plenty of both were going around. Regardless of what anyone says, the Federal Reserve (as well as Wall Street and the Bush Administration) has been unable to understand or accept just how deep and far reaching the liquidity problem really is. If four little towns near the arctic circle in Norway have their budgets destroyed because they lost over $64 Million in sub prime investments, one must ask just how far globally this fiasco is going to reach? No one knows. However, it does answer a question; "where was all the money coming from to buy houses in the US"? Now we know. It was coming from all over the world. When the new fangled securities go bust, investors in these securities world wide will suffer.

A broker in CA summed it up recently. He stated "The real problem is we Realtors sold $375 K homes to many people who could only qualify to buy $200 K homes. Many sub prime and NINA (no income, no assets) borrowers will be unable to remain in their homes even if their current mortgage rate does freeze for 5 years". This is where the real problem lies. Consumers went in over their heads. They borrowed against their home equity for cars, vacations and to pay off credit cards. Home purchases and refinancing certainly fueled the US economy after 9/11. With the sub prime fiasco coming into full light, home prices in most parts of the country are dropping like a rock. And they may have a long way yet to fall. Many US houses are mortgaged to the hilt with some having home equity loans on top of a first mortgage. Many homeowner loans in excess of the present value of their homes. No more piggy banks to rob, so homeowners are loading up their credit cards (again) to continue consuming. Credit cards will be where the next crisis will arise and that should peak sometime in the next two years.

However, sub prime loans are not the only area of concern. In the age of loose credit, homeowners were not the only ones doing risky borrowing. There were a lot of corporations with less than stellar credit risks borrowing large sums of money as well. Junk bonds and junk financing were used by small and large businesses alike. So, it won’t be just homeowners defaulting on loans. One might argue US exports will keep the economy strong. The weakening US dollar does make US products more attractive overseas. That can be a good thing. However, the United States is carrying record levels of debt. A large amount of US debt is being held by other nations, such as China. These countries are seeing their investments erode as the US dollar rapidly loses ground against other currencies. At what point do these countries decide to unload dollars in favor of Euros or other currency causing a panic selling of US securities? US interest rates would have to increase in order to attract investors back into US debt.

Fortunately, for the rest of the world, oil prices worldwide are in dollars. While the US sees higher prices for many products related to petroleum, other countries are not yet experiencing the same effects of $100 per barrel oil. Although that my be short-term. All roads lead back to the problem of “faith”. Until lending institutions and investors feel confident they are going to be repaid, they will not lend money to people or corporations. Until money starts to flow again, the current credit crunch will remain in place. How long before it adversely affects the rest of the economy is anyone’s guess?

Fasten your seat belts. Now is not a good time to be holding large amounts of debt. The next two-three years are going to be very ugly and many people are going to suffer dearly. However, for those flush with cash, there may be some real bargains on real estate, boats, classic cars, etc during the next 2-3 years. Unfortunately, this may be the way Americans learn to live within their means. The Federal Government is in debt up to its ears as well as a vast amount of Americans. The easy credit policies to any and all have gotten the world into this sub prime and securities mess. It is now time to pay the piper.
Copyright Gregory Sweet Tucson, AZ January 4, 2007