The subprime mortgage problems of recent weeks and months has not gone away by a long chalk. There will undoubtedly be interest rate rises to follow on from the eruption.
The loan environment is about to get much worse as marginal loans get reset. Lenders have used “exploding ARMs” (Adjustable Rate Mortgages) before which start at attractively low interest rates, but then reset within two or three years, generally to the London Interbank Offered rate PLUS six percentage points.
Over the next five years, there will be resets for around $1 trillion worth of ARMs. But the problem is even closer, for from June to October 2007, over $100bn of ARMs are set to change, and they are all in the subprime category. As interest rates have gone up in the recent past, these loans that were on low rates are now set to hit 11% or even higher – up more than four points.
In addition to that the number of delinquencies is on the increase, far exceeding target levels when loan pools were sold to investors; and the most recent borrowers probably have little or no equity in their house. This may leave them “upside down” – or with more owing on their mortgage than the value of their home.
Home prices have already flattened, and all this bad news suggests worse is to come. Marginal loans are in trouble as they are backed by assets (subprime) which are not performing as hoped, and consumers will find it ever harder to buy as their financing becomes restricted.
Some industry watchers feel that there should be more regulation to protect consumers from this sort of future problem when they sign up to a seemingly great deal. But others feel that regulation would be stifling and anti competitive.
The problem is that some products were advertised with such low interest rates that it would be almost impossible to resist. Take one percent as an example. Who is going to look to the future of exploding ARMs when one percent is on offer?
The elimination of the 30 year bond in 2001, thereby forcing foreign central banks to buy the 10 year note than underpin mortgages, seemed to have the intention of boosting house prices.
There has also been a banking cartel which has been a root cause of problems. Regulation of mortgages won’t fix that. Recklessness and imprudence have been studiously ignored. Thus, more regulation in one area will simply show up another area where regulation is weak – creating another potential bubble. Banks have shown little concern for making loans so long as they don’t get the problem (that is, they don’t have to give up any assets), and charge lofty fees as they go. They will look to offload the problem to pension funds, risky hedge funds and foreign investors.
Remember these: the 1980s oil finance bubble; the S&L fiasco; Long term Capital Management; the NASDAQ bubble. All these investment bubbles were blown up with bad loans and leveraged speculation using other people’s money.
And who suffers in the end?
As ever, the general public has to pay the price.