SubPrime Crisis 101

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With all the stuff happening with the markets and the news that there are now cannibals running around on wall Street frightening investors perhaps I should replay a post from January (pre PE). Then I'll add some on the end about what is happening NOW!

This was written BEFORE the current crisis so when I said "which is HUGE" THAT part is now happening.
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FIRST - I am not a professional - this is my take on things. Anything you see inaccurate please let me know!

Many people talk about the Sub-Prime problem but few actually understand what it is, why it's a problem or just HOW big of a problem it is (which is HUGE). So I thought I would explain it in a layman's way from both sides of the ledger.

This story is repeated a millions times but it's basically all the same - just pretend that John Doe is 5 million John Doe's. The numbers are only for example, just to give you an idea.

It's 2006.

John Doe works at McDonald's and makes $30,000 a year as a manager. He wants to buy a nice home and knows he can afford to pay $1500 a month and with the raising home prices his equity will grow. He see's a house he likes for $200,000 and goes to a random mortgage broker.

The broker asks, "how much do you make a year" and John Doe says . . . . . "ummmmm $400,000" and the broker says, "fair enough. I can put you in this home with no money down. I can even give you 110% of the amount you are asking. Your loan will have a rate for 3.5% for the first year and 10.5% after that. All you have to do is refinance within a year with the extra money you are getting. No problem, home prices are skyrocketing, you might even flip the house and make MORE money".

"Everybody is building new houses all over the place, they are popping up like mushrooms and people are buying right and left. Prices are going up, now is a good time to buy".

John Doe thinks about it and figures it's risk free, no money down, in fact he is getting PAID to buy a house and he takes the deal since home prices ARE going up!

THIS is a sub-prime loan. See the problem? Just wait it gets WAY WAY worse.

The Mortgage Broker then receives a huge amount of money for making the deal and when he talks to the Lending Officer who asks "did you check out the financials?" and the Broker says ,"yea sure" and the Lending Officer says "great, then so did I and all seems perfect" The Lending Officer then sells the mortgage to a Wall Street firm , the big investment houses like Bear Stearns or Merrill Lynch, Fannie May & Freddie Mac and so forth and he receives a huge amount of money for selling this loan.

Now Bear Stearns or Merrill Lynch, Fannie May & Freddie Mac and so forth have these loans and package them into High Yield AAA Mortgage backed bonds. Then with the help Standard and Poors, (who receive a huge amount of money from Bear Stearns or Merrill Lynch and so forth) sells the bonds the big boys such as Government retirement funds and huge foreign banks, and so forth.

As you see, EVERYONE in the chain passes on the these subprime loans to the next guy up the chain and at the same time gets paid major money.

And all is well. As long as people pay their mortgages everybody is making money all is good and everyone is getting rich.

BUT WAIT! All of a sudden there are too many homes on the market and John Doe's $200,000 house value dropped in price and has NOT gone up!! It's only worth $190,000 now because other houses around him are not selling. Mr. Doe goes to his lender to refinance because his rates are about to go up from 3.5% to 10%. HOWEVER - he is told that his house is not worth $200,000, he is "upside down" and they will not refinance, he owes more on the house then what it is worth.

He will have to pay a 10.5% rate.

Hmmmmmm - instead of a $1500 a month loan it's now $4000 and no way can he pay that much. And since he actually has zero money down and can not afford $4000 - he does not care or can do nothing about it, he is over his head!!

He moves away not caring about the house and the bank forecloses his dream house. He has bad credit but at least he is not $200,000 in debt.

Now the real problem comes. Millions of houses are being foreclosed. Those AAA Bonds, the ultra safe ones? Are now only worth fifty cents on the dollar IF they are lucky! Corporations that purchased these ultra safe High Yield AAA Mortgage backed bonds are seeing their value plummet. They are not MAKING money but losing it by the truck load.

Now another problem is happening. All the money that was suppose to go for new buildings and development, or pension funds that earn income . . . . has dried up . The same buildings that drives the American economy has come to a grinding halt.

All of the workers that had been getting paid are being laid off or finding there is nothing to build and now THEY are having problems making payments.

As a result over one hundred subprime mortgage lenders have failed or are filing for bankruptcy. New Century Financial Corporation, previously the nation's second biggest subprime lender is one of them. This adds to the problem. Even the companies that foreclose house's are going bankrupt. 6.5 TRILLION dollars in mortgage's have gone belly up - BLINK - disappeared!

Now with market paranoia setting in, banks have reined in their lending to each other and to business, which led to rising interest rates and difficulty in maintaining credit lines. As a result, ordinary, run-of-the-mill and healthy businesses across the world with no direct connection whatsoever to US subprime suddenly started facing difficulties or even folding due to the banks' unwillingness to budge on credit lines.

Another tiny problem is many times no one really knows WHO owns the foreclosed house. There are so many fingers dipping in the pudding and the loan has been broken up into so many pieces, no one knows who to buy the house from if then wanted to buy it.

Most experts think we are not even CLOSE to the bottom and maybe only 40% into this mess! This is the worse mess for Wall Street . . . EVER! This is why all of a sudden Wall Street and the markets are sitting up straighter and saying SHIT!!!! We're in deep do do!!!

American International Group, Inc. (AIG) is the worlds 18th largest company and is also a sub-prime company and has suffered a liquidity crisis following the downgrade of its credit rating, the United States Federal Reserve loaned money to AIG at AIG's request to prevent the company's collapse.

Of course with the HUGE banks having problems with money this trickles down to the smaller banks and this is why the Fed want to spend $700 billion of your money to help the Financial sector out of their mess and buy all of these bad loans and stabilize things.

So should you be worried? I'm not. What good would it do anyway. Just hang tight and look at it as another bump in the road. As Maria Bartaromo from CNBC say's "it will all straighten out eventually, just hang tight and don't panic".
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We sold our house in Madison because of a coin flip.

Our house started on the market at $220,000 and after 4 months we had been dropping the price and were STARTING to get worried because of the housing problems AND because we really did not want to pay for two mortgages . . . in fact we could NOT pay two!!

In the nick of time some people looked at the house which was on a nature preserve and the family liked TWO houses. The husband asked the wife which one she wanted. She could not decide so the flopped a coin. WE WON.

And that is why we were able to moved to Columbus. A freaking coin flip.
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Have a great day!