Subprime: The Ultimate Financial Accident

Bill Bonner
Provided as a courtesy of Agora Publishing & DailyReckoning.com
Nov 21, 2007

"Radioactive Paper" is how Forbes describes it.

Forbes referred to various forms of securitized debt, of which subprime CDOs have probably gotten the most media attention.

You'll remember how we got to into this mess, dear reader. The whole thing was chronicled in these Daily Reckoning pages. Thanks to a mixture of good luck and bad management, the United States was able to heat up the entire world economy. But now, it's in hot water itself. Americans are up to their necks in boiling debt while Wall Street has its vaults stuffed with the kind of debt that sets off Geiger counters.

The warnings began earlier in the year. But it was only this summer that the indicators flashed a "Meltdown" signal. Since then, the papers have been announcing one calamity after another. We're going to skip the details and go right to the big picture...

The big picture is this:

• The United States has a consumer economy... 70% of GDP is consumer spending
   
• 20% of the entire world's spending is done by Americans
   
• Americans counted on house price increases... not only for current spending but for future spending; they expected to retire on them
   
• Now that house prices aren't rising... something has to give

A pause: Here's Money Magazine's Myth #13 about retirement from their recent "Retire Rich" issue:

"Treating your house as the ultimate retirement insurance is an easy trap to fall into. Even with the housing market in the doldrums, the five-year real estate bull market has likely left you feeling house-rich. According to a 2004 study by the National Economic Bureau, upper-income boomers ages 51 to 56 have a third of their net worth invested in their principal residence.

"As recently as May, a survey of affluent boomers by financial adviser Bell Investments Advisors found that nearly 70% were relying on their homes as a retirement asset. Question is, will the strategy work? The answer is, not that well.

"Why? Because it's hard to eat out on your home equity. You have to live somewhere. To turn your equity into cash, you can sell and then rent, move to a cheaper area or downsize. Most retirees prefer to stay put. Yes, you can do what a small but growing number of retirees are doing: Get a reverse mortgage, which is a loan against the value of your house that you don't have to pay back. (When you die or move out, the loan is paid off by the sale of the house, which means you may not be able to pass the home on to your children.)

"But these loans give you much less than the value of your house. For homeowners ages 62 to 69, lenders will typically let you borrow just 49% of your home equity, says Wharton finance professor Nicholas Souleles.

"The best way to look at your house is as a place to live, not a retirement account. So in the years leading up to retirement, don't over-invest in it with the idea that you can get that money out later. Keep your mortgage and other housing expenses to no more than 28% of your income, and don't prepay your mortgage instead of saving for retirement."

Back to our discussion:

All this has been obvious to us for a long time. Still, until this summer, nothing gave. Consumer spending continued to rise!

But now, the latest news is that consumers are finally slacking off. Auto sales are plummeting, for example.

Of course, the first thing to go was spending on houses itself. The builders got nailed. And then, the people who financed the builders... and who lent mortgage money to borrowers who couldn't pay it back. But nobody seemed to care... until the 'radioactive paper' - derivatives based on mortgage debt - started to melt down. All of a sudden, a 'Credit Crunch' was in the headlines... and Wall Street was on the phone to central bankers.

At first, hardly anyone knew what a credit crunch was. People thought it was a new breakfast cereal. The newspapers had a problem with the story from the get-go. They didn't know whether it should run in the finance section... or the Police Blotter. Subprime lending could have been a crime story... or a financial accident; they didn't know.

Then, the banks began to announce losses... and the numbers grew. A hundred billion here... a hundred billion there... pretty soon, we were talking about real money.

The latest estimate comes from Goldman Sachs (NYSE:GS). Goldman says total losses from subprime lending will hit $400 billion. But the golden boys go on to say that the losses to the economy will rise to $2 trillion.

Ah, yes, dear reader. That is how a credit crunch works. When credit is expanding, a relatively small amount of money is leveraged into a big amount of money. A borrower might use $100 million deposit, for example, to anchor a loan for $1 billion. But when credit contracts, leverage works in the opposite direction. A hundred million of capital disappears... and the $1 billion of loans are withdrawn. Altogether, Goldman expects $2 trillion in cash and credit to evaporate.

This is bad news for the U.S. consumer... and for the people who sell him things. Already, there is "alarm at rising U.S. car loan defaults," says the Financial Times. And gasoline in the United States rose 13 cents in the last 2 weeks.

And, remember... the consumer has to eat! Food prices have been going up five times faster than the reported CPI.

Give them enough time and even economists can put two and two together. Now, more and more of them are predicting a recession. And everyone has his eyes on the holiday sales figures.

But... and here is a fairly big but... a Texas-sized but, in fact: so far, the stock market has edged down... but it has not crashed. Our 'Crash Alert' flag is still flying. And we've had some exciting 300+ point declines. Just yesterday, the Dow went down more than 200 points. But no crash.

You'd think investors would want to get out. You'd think they'd at least want to watch what happened from the sidelines for a few weeks. But so far, we've seen only a steady retreat... no panic. No crash. No collapse.

The old market hands are wondering... what does the market see? How come it doesn't correct in a major way? Do investors really think that the declining dollar will save them... ? Are they expecting another big rate cut from the Fed (Bloomberg says another 3/4 point is coming... )? Do they think it will all blow over... instead of blowing up?

More tomorrow... and the day after... and the day after...

Here, we stroll... perambulating and cogitating... with reflections that bounce back on one another.

The subject is contrarianism. We know it works in the investing world. "Buy when blood is running in the streets," was how Jacob Rothschild put it.

But if it works in investing, how about the rest of life? "You are either a contrarian... or you are a victim," says our old friend Rick Rule. Crowd followers are the victims of the financial markets. Last week, we saw how ordinary soldiers are the victims of wars. Today, we walk a little further down this hall of mirrors... hoping to see something new.

We watched a little television while we were in Ireland. A group of grown Englishmen caught our eye. They were jumping up and down like children... whooping and clapping... What were they so happy about? Their team had won. They had won. They were winners. They stood taller. They were prouder. There was real joy in Mudville.

The men didn't look like winners. They looked like losers. They were out-of-shape... poorly dressed in tee-shirts and jeans... with stupid expressions on their faces. And yet, as if by a miracle akin to transubstantiation, they were made winners... What had they done? Nothing. What merit or skill had they revealed? None. And yet, they felt like winners, simply because the home team had scored more points than its opponents. They were fans caught up in sports... emotionally and intellectually. Far more mental energy goes into second-guessing coaches at sporting events than went into the Brandenburg Concertos or War and Peace.

"You know," said Elizabeth, "you risk becoming so alienated you can't take part in these things... and you can't enjoy them. You risk putting yourself so far away from everyone else that you are like a man with his nose against a pane of glass... like Frankenstein's monster... looking in at the human race. It will be very lonely...

"You might also think of Rhett Butler in Gone with the Wind. Now, there was a real contrarian. He knew the war was a lost cause. He urged his fellow southerners not to go to war in the first place. Then, instead of joining up himself, he profited from the war... he was a blockade runner, remember? But even he couldn't stay out of it for long. Near the end, when the Great Cause was almost lost, he joined the Confederate Army. He didn't have to. He knew it was hopeless. But he did it.

"It is all very well to be a contrarian... but we are human too. And humans operate on instinct... what's more, many of those instincts are noble and good. You don't want to put yourself at too great a distance from those instincts... or you will cease being human at all."

A Greek philosopher - we can't remember which one - argued that the greatest curse a man can suffer is to be married to a smart woman. She will laugh at his pretensions and find the flaws in his arguments. No, what a man needs is a good woman... he said, one who makes cookies and looks adoringly at her husband, as she would at a cocker spaniel.

But the Greeks were wrong about a lot of things. A smart wife is a man's greatest protection from his own absurd logic and his own preposterous vanity. She will point out that he is a fool... and he will see that she is right.

Contrarianism, as a philosophy, only takes us so far. (We are not contrarians... long term Daily Reckoning sufferers will remember. We are Essentialists. Distill the transaction down to its bare essentials, we say. Then, find the rule that governs it. More on that when we have nothing better to do... )

Getting back to our subject... modern wars, often, are like sporting events. There is a logic to them. But we are often as bamboozled by [our] own logic as we are misled by our instincts. Take the American Revolution, for example.

The history books tell us that it was a war of liberation. 'No taxation without representation,' was the War Party's cry. And yet, an Englishman lays out the facts:

"One of the great ironies of the American Revolution," writes Martin Hutchinson, "is that the colonists, who rebelled against British-imposed taxes lower than those of the mother country, were in reality living in the lowest tax polity in the history of civilized mankind. Needless to say, once the United States had achieved independence, the taxation on its people was never as low again, even though for the country's first century and a half most U.S. governments pursued admirably frugal policies."

The Founding Fathers were driven by their own instincts and deceived by their own logic. It happens to the best of us.

Nov 20, 2007
Waterford, Ireland
Bill Bonner
email: DR@dailyreckoning.com
website: The Daily Reckoning

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