global agenda 88.
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A new wave of selling struck the markets this week, but this time nobody bothered blaming the Chinese. Even the new bogey-man of "the Japanese yen carry-trade" took a back-seat, in favor of "sub-prime" debt. The emergence of serious and widespread problems regarding sub-prime debt in the US, we were told, had spooked investors around the world.
Two questions demand immediate answers: a) what is sub-prime debt? B) if it's an American phenomenon, why did stock markets in Japan and Europe fall further than those in the US?
First, let's deal with definitions. Sub-prime debt is, in the official or politically correct version, loans advanced by financial institutions to borrowers whose credit score - ie ability to service and repay the debt - is low. In plain English, sub-prime debt is money thrown at people who by any accepted standard of prudent lending should not have been allowed to borrow at all. However, in the real-estate mania that gripped America from 2002-2006, lenders - banks and mortgage companies of various sorts - threw normal lending behavior out of the window. They invented new and risky loans, such as "ARMS" - adjustable-rate mortgages - that offer a cheap and enticing rate of interest for the first two years, before reverting to market rates that update every six months. They then went after people on low-, no- or unstable incomes and gave them the money, often without demanding even the most basic information as to their financial position or prospects.
It doesn't end there. These loans, once made, were then packaged by sophisticated "financial engineers" in investment banks, sliced up in "tranches" with varying degrees of risk, bundled up in large bunches thereby supposedly spreading the risk widely, packaged into bonds and labeled with a good rating from a reputable rating agency - and then sold to pension funds and other institutional investors around the world. In short, different banks made money in different ways along a long and complex food chain. At every stage, the dupes - the borrowers of the loans, and the investors in the pension funds, are the ones set up to suffer the most damage, when things turn sour.
That things would turn sour was an inevitability. In order to understand why, it's useful to reduce the overall phenomenon to an individual case. CNN did this by profiling a young family in Massachussetts that saved $5,000 to make a deposit on a house. However, this amount only covered the fees on the purchase, because the house cost $290,000, so they paid for it by taking two mortgages, one for $240,000 and one for $58,000. The former was an "ARM" and the rate has now reset at a much higher level. Surprise - they are falling behind on their payments and are threatened with foreclosure. In this case, the lender is prepared to be flexible and offer them better terms, because the last thing it wants is to have the house on its hands - now that home prices are sinking and property is much more difficult to move.
This is as good a nutshell as you can find to see what happened and why it was a certainty that it would fall apart, with horrendous consequences. Many commentators - including this column - warned about what was happening and where it must lead but, as usual when the mania rages, the herd paid no attention since they were sure that their heavily leveraged investment would justify itself when house prices continued to rise. House prices eventually stopped rising in 2005 and spent most of 2006 in a downtrend. As more and more borrowers default and lose their homes, the excess supply on the market will keep prices under pressure - perhaps for years to come.
The most aggressive lenders are also coming unstuck. Those that were independent outfits are beginning to go bust, but for mortgage units within larger banking groups, the process of exposing and then expunging the bad debts takes longer and is absorbed within the overall activity of the group.
However, the rising tide of loan delinquency is forcing all banks to finally and belatedly restore some sanity to their lending procedures.
The reduction of credit availability, on top of the loss of the stream of capital gains, at least on paper, that American consumers had become accustomed to generating from the rising value of their homes, is forcing consumers to retrench. That's what the rest of the world is so worried about - because American consumers kept most of the rest of the world in clover since 2001.
The good news is that the rest of the world is managing to move ahead despite the slowdown in America - at least so far. Indeed, foreign demand is boosting American exports so that at last the huge deficits in US trade and the balance of payments are beginning to shrink. The long-awaited "adjustment" in the global economy is underway. There is no chance that it will be pleasant for the US, but if Europe and Asia can keep their regional economies growing, it doesn't have to be disastrous.