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2007: Naughty Banks Spanked- by Greg Strid

The meltdown in the market for subprime mortgage
securities is fast unraveling into a banking crisis that
threatens to drag the American economy into recession.

During the final stretch of the greatest housing bubble
in American history, financial institutions were tripping
over themselves to extend excessive amounts of credit
to prospective buyers that were lacking in both
qualification and responsibility.

No document loans, interest only loans, and option ARMs
(loans that did not even require the full payment of interest)
were all the rage. No need to verify income, no need to
cough up a deposit- those practices were so last century.

These ‘innovative’ loans were peddled by unscrupulous
mortgage brokers, and sold to Wall Street investment
banks. From there they were bundled together, and then
stamped with approval by ratings services employed by
the bankers, and finally, they were sold to yield-hungry
investors around the globe.

The frenzy in mortgage lending was accompanied by over-
investment in the housing stock (which was fueled by
borrowed money as well). Everything worked smashingly
well until it didn’t. Eventually, supply overwhelmed
demand, as it often does when a market is offered cheap
and virtually limitless credit.

Home prices began to sputter in the hottest of the hot
markets: Southern California, Las Vegas and coastal Florida.
A staggering amount of loans in these areas were of the
subprime variety, equipped with artificially low teaser rates,
requiring no money down. (This all works fine as long as
prices are rising; homeowners can refinance or sell as long
as the tide of prices continues to rise.)

As prices declined, and mortgage resets kicked in, people
with shaky finances and no equity were forced to sell, and
many simply defaulted altogether. This, coupled with over-
building, set off a nasty price decline that picked up
momentum this year- one that shows no sign of slowing.
And, areas outside the hottest markets are suffering as well.

This is where the banks come in. They not only repackaged
and sold these now worthless mortgages as investment-grade
securities, but they borrowed to buy them, or were unwittingly
exposed to them (and a slew of derivative products tied to
them as well).

And, these investments were kept off the balance sheets, in
line with regulations, allowing them to avoid setting aside
proper amounts of capital to deal with potential losses. The
fees generated from peddling these bogus products, coupled
with the extra capital freed up by keeping this activity off of
the balance sheet, allowed for the generation of obscene profits.

Now America’s once cherished investment and commercial
banks are scrambling to cover massive losses associated with
subprime lending. Multi-billion dollar portfolio write-downs
are announced with regularity, and banks are selling huge
equity stakes to sovereign wealth funds in a desperate
attempt to repair financial wounds.

Banks no longer trust one another- they were all drinking
from the same tainted punchbowl. Lending standards are
tightening across almost every loan category. The supply of
credit, the lifeblood of consumer spending and capital
investment, is slowing. This will cause economic growth in
America to come to a halt. Given the severity of the credit
problems faced by American banks, current levels spending,
investment and employment will inevitably decline.
Next stop: recession.

© Greg Strid 2007

© 2007 Splendid Marbles.