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What Do Sub-Prime Loans Have To Do With The Stock Market?

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For years, the residential real estate market boomed. Sub-Prime loans—loans made to folks with poor credit—helped drive this boom. The most important economic support for the boom was easy credit. Interest rates were very low compared to historical norms and the risk to lenders for making these loans was also low because once made, lenders were able to sell the contracts to other institutions, leaving themselves unaffected if borrowers later defaulted on the loans.

Who eventually ended up owning those loans? They were purchased by financial institutions who packaged them into high yielding securities called CDOs (collateralized debt obligations) which in turn were sold to hedge funds whose shares were purchased by high net worth investors.

This was a good deal for a while as the value of homes were bid up by the influx of new homebuyers and speculators able to borrow on easy terms. These variable rate contracts obligated homeowners to pay higher interest costs when interest rates later rose. Some of these loans didn’t require any down payment, so people were “owning” homes without any equity interest in their home at all. Lacking experience and good advice, new homebuyers didn’t understand what could happen if and when interest rates rose. For many, this seemed like their only chance to own a home. They hoped if rates did go up later, by then they would be able to handle the increased costs. 

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Eventually, the Fed did raise rates, mainly to control inflation (the reality of which is often understated). But by the time interest rates rose substantially, more new homes had come onto the market than there were qualified buyers to purchase them.

So the real estate market in many parts of the country began to cool. As demand for new housing dried up, demand for existing homes did too. With declining home values, many homeowners owed more on their mortgages than their homes were now worth. With interest rates rising, some of these homeowners couldn’t pay the increased mortgage costs and were forced to sell. But selling their homes didn’t cancel the debt because their debt was more than the value of their home. Many of these loans went into default. As they defaulted, the value of the securities into which these loans were packaged declined precipitously and those high net worth investors lost money.

So investors, who were once a source of capital for mortgage lenders, once they began losing money, now wanted out of these investments and money for risky loans dried up. Now buyers with poor credit can’t get mortgages. With fewer people qualifying for new mortgages and with so many people unable to make payments on the mortgages they have, the downward pressure on home prices is exacerbated.

Unfortunately, the fear associated with sub-prime loans losses appears to be carrying over into other markets and now other loans are hard to get too. Many people are arguing that the Fed should now come to the rescue by lowering rates to make it easier for individuals and businesses to get the credit they need. But for the Fed, that presents a problem.

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Essentially, the US is living on borrowed money and borrowed time in the same way that many individuals are. We borrow from China and other countries by selling them our bonds. We borrow to fund our wars and maintain our lifestyle. Some countries may decide they don’t want to buy any more of our dollar denominated bonds given that the dollar is likely to be worth less later than it is now. Of course the Fed can print money if it wants to, but printing more money when there is not an equivalent increase in the amount of goods and services being produced means more dollars are chasing the same amount of goods and services. This bids up the price of goods and services and we call that inflation. Inflation is a reduction in the value of the dollar.

Inflation means things cost more then they used to. And when things cost more than they used to, some families can no longer afford to buy what they need or want. And if these families have no savings to fall back on, the only way they can get by is by borrowing on their credit cards or taking out second mortgages. But Americans have been doing just that for a long time now. Americans have the lowest rate of savings in the industrialized world. Now a lot of folks have no savings to fall back on and no more credit either. Many will need to sell their homes, and some will go on welfare.

Americans will likely have less discretionary funds with which to buy cell phones, dish washers, tv sets, and everything else. This suggests that retailers are going to sell less, unemployment will increase, and wages will stagnate. Times will get tougher than they have been. The people who will be hit the hardest will be those who are least able to cope: those who are already tapped out; those who have lots of debt; and those who don’t have marketable skills. The middle class is moving down a class.

What will this do to the stock market? Actually I don’t know, I can only guess. But now stocks are riskier. People who already have lots of money will buy stocks at bargain prices when average Americans are forced to cash in their equities to pay current living expenses. The gap between the rich and poor will widen.

The wealthiest among us will end up owning more assets and having more bargaining power over the rest. They will grow their wealth by investing their capital and selling goods and services to whoever has money… if not here, then in other countries. America will begin to look less like a super power and more like a lot of other places on the planet. Large multinational corporations and the most well-healed players will probably do ok. Inexperienced investors will continue to invest in things they don’t understand and the stock market will reflect the dislocations to which I’ve alluded, until that which has been dislocated becomes the norm. None of this had to happen.

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Mark A. Goldman is an author, financial planner and was a candidate for president of the United States in 2008 and 2012. His new book called "Starting Over" is available for download free as a pdf file at this address: (more...)
 

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