Business News

Milwaukee futurist predicted subprime collapseBy Bob Chernow , for SBT

Published September 14, 2007

Editor's note:
The author, Bob Chernow, prefers to speak his mind on the condition that he be referred only to as a Milwaukee businessman, because he is speaking strictly from his own perspective, and his viewpoints do not represent those of his company. He has more than 30 years of experience as a stock broker and is a noted futurist. The following are excerpts from a speech Chernow gave at the World Future Society in Toronto, Canada, in July 2006. Many of his forecasts about a pending crisis in the subprime lending market and a credit crunch are coming to pass.

VIEWPOINT
In the early 1970s, the Hunt Commission deregulated the S&L and Mutual Savings industries. Deregulation gave them freedom, but there was little oversight regulation over them.

The S&L and Mutual Savings industry borrowed their money short-term, but made long-term loans. This strategy was doomed in an inflationary economy.

Deregulation and the lack of oversight led me to predict the collapse of the industry - something that I tried to prevent in a series of speeches and articles to the industry and letters to my senator, Bill Proxmire (then Chair of the Senate Banking Committee) and the Federal Home Loan Bank, now part of the Federal Reserve.

In addition, the "guns and butter" policies of President Lyndon Johnson and President Richard Nixon's imposition of price controls (without making changes in the economy) made inflation inevitable.

The lack of any response made me understand what it means to be a "Cassandra." You can see the future, but you are cursed that no one believes you!

Now I have another dire prediction. This one concerns trends in mortgage finance. Mortgage lending is based on the premise that the homebuyer or lender has a stake in a property. Federal regulations require a 20-percent down payment if no mortgage credit insurance is involved. Mortgage insurance from private industry covers either the top 20 percent of a loan or the entire mortgage. This tactic is designed to ensure that appraisals are not inflated and that the lender has a vested interest in being "honest." FHA and VA credit insurance also has controls to ensure that appraisals and credits are in line with reality.

Yet in "hot" real estate markets, many buyers avoid mortgage insurance because lenders encourage them to take out second mortgages as down payments. These second loans have higher interest rates and are often adjustable to variable interest rates. These types of loans encourage speculation by artificially allowing buyers to stretch what they have to buy homes they normally could not afford.

According to the Federal Reserve, 35 to 40 percent of all recent mortgages were "interest only" variable loans. This type of mortgage allows buyers to buy homes when prices are inflated. It is interesting that the last time interest only and balloon mortgages were popular was during the 1920s. This was a major reason that banks became insolvent during the depression and was a reason why amortized mortgages were created, as these types of mortgages let buyers pay down principal.

What is wrong with "interest only" mortgages? Well, for one, the homeowner has no economic stake in the property. He can walk away if he cannot pay. He is, in essence, "leasing" the home in the hope that property values will increase. This is the "greater fool" theory of investing. What's that joke? "If you don't see a greater fool, look in the mirror!"

Fourteen percent more homes were lost to creditors in 2005 than in 2004. Realtytrac.com says that 33 percent more people are in some state of foreclosure than in 2005. What is interesting is the number of the affluent that these numbers represent. Regardless of what the "new" bankruptcy law dictates, banks will be hard-pressed to collect on much of this debt.

Note as well that $2 trillion of variable loans are due to have their interest rates reset shortly. What we have seen so far may only be the tip of the iceberg.

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