Casey
Files: The Second Crash - On the Way and Unstoppable Doug Hornig
Editor, BIG GOLD
May 29, 2009
Tuesday,
October 9, 2007 started as a nice day in New York City. A
lovely early fall day, with the temperature still a balmy
80° at 2:00 in the morning. By evening, though, the temperature
had dropped twenty degrees, the clouds had rolled in, there
was thunder and rain.
As with the weather, there were some hints of trouble here
and there on Wall Street. But all in all, things could not
have seemed better. Little did we know, the stormy end of
10/9/07 signaled a very large bubble that had just popped.
That was the day when the Dow Jones Industrial Average hit
its historic peak. From there, it was all downhill - slowly
but steadily at first, and then violently after last August
- until the Dow bottomed (for now) on March 9 of this year.
Over that span, the index lost 54% of its value.
It's been a crushing blow to just about everyone. But it's
already being referred to as the crash. As if the unpleasantness
were now all behind us. More likely, in the future it will
be seen as, simply, the first crash.
Don't believe it? In a moment you will, when you see the
scariest graph of the year.
But let's quickly recall what's already happened. During
the late, great housing boom, interest rates were at microscopic
levels, while bankers were encouraged to grant home loans
on little more than a wink and a nudge. In order to inflate
their balance sheets, those bankers resorted to all sorts
of gimmicky, adjustable rate mortgages (ARMs), whose common
feature was an interest rate that would eventually reset.
That is, it would balloon somewhere down the road. And those
most likely to come quickly to grief were the riskiest borrowers,
who held loans known as "subprime."
"But not to worry," borrowers were told. "Betting
on ever-rising home prices is the safest wager in the whole
wide world. If you have problems with cash flow when the ARM
resets, your house will be worth a lot more, so you can simply
sell it and walk away with a nice chunk of change in your
pocket." Uh-huh.
The bankers themselves were a little more concerned about
the deterioration of their portfolios. They took out insurance
in the form of credit default swaps (CDSs). These were a brand-new
invention in world financial history, allowing mortgages to
be sold and resold until they were leveraged 20 times over.
They became the shakiest part of a huge global derivatives
market, with a nominal value in the tens of trillions of dollars.
For a while, this Ponzi scheme even worked. But then, as
they had to, the ARMs began resetting, and there were defaults.
Then more of them. Because at the same time, the housing market
was cooling off and the economy was stalling out. More and
more people were trapped in a situation where they owed more
on their home than they could sell it for. Many simply mailed
their keys to the bank and moved on.
All of this wreaked havoc in the derivatives market. Sellers
of these exotic packages could no longer establish what they
were worth. Buyers couldn't determine a fair price and so
stopped buying. As the ripples spread through the world financial
system, trust disappeared and liquidity dried up.
Now consider that the base cause for all that dislocation
was the subprime sector. And how big is that? Not very. Subprime
mortgages account for only about 15% of all home loans. Their
influence has been way out of proportion to their numbers,
because of derivatives. Here's the good news: the subprime
meltdown has about run its course. These loans were resetting
en masse in 2007 and the first eight months of '08. Now they're
pretty much done.
And the bad news? No one in the mainstream media seems to
be asking what should be a pretty obvious question: What about
loans other than subprime? Truth is, the banks didn't just
trick up their subprime loans. ARMs were the order of the
day - across the board.
Now, here's that frightening graph we referred to earlier.
Take a good, long look. You can see that from the beginning
of 2007 through September of 2008, subprime loans (the gray
bars above) were resetting like crazy. Those are the ones
people were walking away from, sending a shockwave from defaults
and foreclosures smack into the middle of the economy. Now
they're gone.
The ARM market got very quiet between December 2008 and March
2009, hitting a low that won't be seen again until November
of 2011. Small wonder a few "green shoots" have
poked their heads above ground. But in April, resets began
to increase and will reach an intermediate peak in June. After
that, they tail off a little, going basically flat for the
next ten months.
It's not until May of 2010 that the next wave really hits.
From there to October of 2011, the resets will be coming fast
and furious. That's 18 months of further turmoil in the housing
market, and the beginning is still nearly a year away! (Although
the months in between are likely to be no picnic, either.)
While it isn't subprime ARMs that are resetting this time,
neither are they prime loans. Those eligible for prime loans
wisely tended to stay away from ARMs in the first place, as
indicated by the relatively small space they take up on each
bar.
No, the next to go are Alt-As (the white bars), Option ARMs
(green) and Unsecuritized ARMs (blue). Alt-As are loans to
the folks who are a small step up from subprime. Unsecuritized
loans are a 50-50 proposition; either the borrowers were good
enough that they weren't thrown into the CDS pool, or they
were so risky no one would insure them.
Those two are bad enough. But Option ARMs are the real black
sheep, loans with choices on how large a payment the borrower
will make. The options include interest-only or, worse, a
minimum payment that is less than interest-only, leading to
"negative amortization" - a loan balance that continually
gets bigger, not smaller. Imagine what happens with those
when the piper calls.
Once the carnage begins, will it be as bad as the subprime
crisis? That's the $64K question. Perhaps not. For one thing,
subprime loans were a much larger chunk of the market when
they started going south. For another, there's been a lot
of refinancing as interest rates dropped; that should help
ease the default rate. And the government has massively intervened,
with measures designed to prop up those who would otherwise
lose their homes.
On the other hand, we're in a severe recession, which wasn't
the case when the subprime crisis started. More people will
be unable to meet payments. And the housing market has continued
to decline, pressuring both marginal homeowners and banks
that can't sell foreclosed properties.
Is the stock market's next 10/9/07 on the way? Yes. Which
day will it be? That's unknowable. It could be in a week,
or not for another year.
But make no mistake about it, the second crash is coming.
It can't be prevented, no matter what desperate measures Obama
and his hapless financial advisors come up with. All we can
hope for is that, with a little luck, it won't be as severe
as the first one. But it will last longer. We aren't even
in the middle of the woods yet, much less on the way out.