REFLEXIONS
The Subprime Roundelay 
“Don’t Worry, Be Happy”
By Robert Ross

 

 

“Here is a little song I wrote,
You might want to sing it note
    for note,
Don’t worry be happy,
In every life we have some trouble,
When you worry you make
    it double,
Don’t worry, be happy......”
    
— Don’t Worry, Be Happy,
 by Bobby McFerrin

Here is a little song I wrote, following the melody of Bobby McFerrin’s popular song. It too, is a roundelay — a song with a recurring theme.
“Here is a little song I wrote,
You might want to sit and take some notes,
Don’t worry, be happy,
In every life we have a bubble,
When you worry, the Fed makes
    it double,
Don’t worry, be happy......”

 
So, we had a bubble, the housing bubble. Just recently Merrill Lynch pulled out a giant pin and pricked the bubble. Should we be worried or be happy? In 2005, the Economist magazine referred to the housing bubble as the “largest bubble in history.” Currently, some are following Bobby McFerrin’s refrain of not worrying and being happy. Others are saying this is it, the beginning of the end. The recent run on Northern Rock Bank in England was merely a harbinger of things to come.

Over the coming months and years, we will be living through the ramifications of this bursting bubble. The question that is on everyone’s mind is “where is this going?” Let’s take a look.

The Dance
Back in 2000 and 2001, there were two major blows to the economy. First, the dot-com bubble collapsed and then September 11 happened. To avoid a financial catastrophe, the Federal Reserve stepped in and began lowering interest rates. In concert with other central banks around the world and the Treasury Department, the Federal Reserve’s goal was to make sure that our country was awash in money. They succeeded.

Soon though, we were in the middle of a new bubble, a new mania, this time affecting the housing market. Mortgage lenders were springing up willy-nilly. The party was on! This bubble had a new twist to it though. Banks and lenders had started packaging up the loans they had made and selling them off to investment funds, who were then slicing and dicing these loan packages, using them as collateral, and borrowing enormous amounts of money.

As this game progressed, lenders, knowing that they would be immediately selling the loans, started applying what was referred to as the “pulse test” to potential home buyers. If you had a pulse, you qualified for the loan. No Doc loans, no-money-down loans and teaser rates were common rather than the exception. This was all great fun. Home prices were skyrocketing. Everyone who owned a home or recently purchased a home was feeling rich.

The Inflection Point
In the summer 2007, someone at Merrill Lynch, essentially said to someone at the Bear Stearns Hedge Fund, we lent you money on one of your super-duper subprime packaged doohickeys. The fund is full of loans that will default, loans that will go into foreclosure, and loans on homes that were incredibly overpriced. We want our money back!  Merrill Lynch got their money back. But this was it, the inflection point. Point — game — match. Bubble over!

The Rescue Waltz
When Wall Street got wind of the fact that there was a lot of junk floating around in the subprime hedge fund world (and the banking world, in general), they got a bit concerned. In a period of a few weeks, the market dropped more than a thousand points.

Investors were asking “To what degree is my mutual fund or stock holding one of these packaged subprime fiascos?” “Is my bank as solvent as it advertises itself to be?” It was beginning to look like a panic on Wall Street, until . . . Yep, you guessed it, the Fed stepped in.

The Fed started by lowering interest rates and “assisting” various lending institutions. Countrywide Financial, on the verge of bankruptcy, was helped to the tune of billions of dollars. This little problem instantly became a worldwide phenomenon. Other central banks in Europe, Great Britain, Japan and Australia began “assisting” banks and lending institutions. The party was definitely over. It was now bailout time.

Then, to add a little icing on the party cake, in September, the Federal Reserve lowered interest rates once again, in an attempt to loosen up the money supply. Things were getting interesting. Shall we dance?  

Post Party Blues
The statistics and quotes from the press on the housing market are disconcerting. “The largest foreclosure rates in x amount of years.” “The largest drop in housing prices in twenty years.”  “The largest inventory of unsold houses,” and on and on. There’s talk of a recession, or even worse, a depression.

How long this unraveling of the subprime mortgage fiasco will take, is anyone’s guess. A year? Two years?  Three years?

A couple of things appear to be in the cards. Housing prices will have to adjust down to affordable standards, given that lenders are asking for 20% down, a good credit history and proof of income. Perhaps prices will adjust back to what they were at the beginning of the housing bubble. To those who bought late in the cycle, with some type of teaser loan, watching the home drop in value while house payments increase will be painful.

As housing prices adjust downward, people in general will feel less wealthy, and more apt to forego the trip or a new kitchen granite counter top. As the economy slows, fewer taxes will flow to government agencies. So, it’s fair to say, “belt tightening” will be the phrase of the day.

If we slip into a recession however, the Fed will be left with no other choice than to do what it did in 2001, lower rates, eventually to rock bottom and pump money into the economy. And it’ll be bubble time again. Roundelay time again. And just what kind of bubble? That remains to be seen.

In the meantime, I just can’t get rid of this jingle that is floating around my head,
“Here is a little song I wrote, You might want to sit and review your notes . . . Don’t worry, Be happy.”

Robert Ross can be reached at:  SanDiegoRoss@Yahoo.com   

Copyright  2007 by Robert Ross, all rights reserved


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