Does the subprime meltdown indicate something bad for the economy?

Boy, oh boy, has the subprime market’s crash been making the news. I guess everyone loves a disaster movie, right?

But, a more important question to ponder is how the subprime meltdown may impact the broader economy. Some very smart people believe it’ll lead to the next recession. People like Merrill Lynch’s David Rosenberg and commodities investing great Jim Rodgers have made their predictions known.

I’d be a fool if I said I knew the answer, but I certainly have some thoughts of my own (you know what they say about opinions). I think a lot of the economy’s growth over the last 4 years has been due to the housing market. For example, much of the growth in jobs during this expansion has been due to housing (home building, mortgage finance, real estate brokers). And, mortgage equity withdrawals have certainly been fueling consumer expenditures.

So, if the a good chunk of the economy’s growth has been due to the housing market, what would happen if a few subprime loans defaulted? Those houses would come back on the market, and the bankers who ended up with them would be eager sellers. This could lower home prices at the margin. And, more homes on the market could lead to less home building. How might this impact all the jobs created over the last 4 years in home building, mortgage finance and real estate brokerage? Not for the better.

My fear is that this dynamic feeds on itself. More laid off builders, brokers and mortgage writers could lead to more defaults. Such defaults could lead to greater inventories, lower home prices, and more laid off workers related to the housing industry. Perhaps you can see the same spiral I do.

Added to this, Congress is worried that lenders have been taking advantage of consumers. Action on their part may restrict the mortgage market even further. This could be bad news, too, because folks with adjustable rate mortgages may need to refinance exactly when Congress restricts that market, further exacerbating the problem.

Betting against the US consumer any time since the depression has looked dumb, so I hesitate to spell out this worst case scenario. But, my fear about housing is exactly what kept me out of housing related investments even as they shot the lights out over the last 4 years.

People investing in the housing market now will end up looking brilliant if things don’t fall apart. But, because it’s almost impossible to forecast how bad things may get, I’ll wonder…were they lucky, or good.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Is the subprime crash a potential investment opportunity?

If you haven’t heard, the subprime market is having a tough go of it, lately. Somewhere between two and three dozen subprime lenders have closed their doors over the last several months. Even for those who haven’t gone belly up, yet, things are looking ugly. Subprime lender New Century Financial’s stock is down 93.8% from its peak. Accredited Home Lenders is better off, but still down 73.8%.

What is subprime lending? Basically, it’s the business of making loans to people who’ve been deemed less credit worthy. Such loans are provided at higher interest rates in hopes that the lender can make enough money off higher interest payments to make up for the inevitably higher level of defaults inherent with less creditworthy customers.

In normal economic conditions, these lenders make a ton of money. But, when economic conditions sour, such loans can turn out looking like earthquake insurance sold with insufficient premiums. But, wait, you may be thinking, the economy isn’t doing poorly and interest rates haven’t spiked. The things that usually make such loans go south aren’t happening.

So, what could be happening? When something is too good to last, it doesn’t. Such has been the case with making loans to folks who can’t make the payments. Unfortunately, loans have been made to people where little proof was required to indicate income, called no document or “liar loans.” And, loans were made at teaser rates that were set to adjust at preset times to much higher rates, and those loans are resetting. And, some companies, like Countrywide Financial, made loans where people only had to pay the interest on their loans, and even paying the interest was optional! Meanwhile, each of those lenders were booking profits as if the borrowers were paying interest and principal. What a mess.

Such situations seem to spell opportunity, at least usually. When headlines are screaming that the sky is falling, it usually means that opportunity is knocking. But, I must admit, I’m not sure this is such a good opportunity. How much of a mess is this? Will it spread to Alt-A and prime loans (the next two levels up in credit quality)? How would housing price declines affect this? Do the lenders have enough financial backing to survive a downturn?

If you can answer all these questions, I think you can invest in the subprime lender of your choice. I know a lot of smart value investors who are or have done just this. I’m not following them, though, because I can’t get my arms around the accounting and assumptions for such loans. I understand, theoretically, how such companies make money, but where the rubber meets the road is in knowing their lending, servicing, default assumptions are valid even in high-stress situations. I just don’t know enough to make that bet with conviction.

In addition, interest rates are still low and the economy hasn’t fallen into a recession. What if that were to happen over the next year or two? How would the lenders do if housing prices decline, as they have been, and unemployment goes up? Those are a bunch of tough questions to answer.

Investing in subprime lenders, or even undiversified home lenders, seems a little like selling flood insurance at premiums that won’t cover a 100 year flood. Its only a matter of time before lenders become over-zealous in lending to unworthy credit risks, and that leads to trouble when the credit market turns.

Investing in a subprime lender right now is like catching a falling knife. If you do it right, you make off like a bandit. If you don’t, you’re going to end up bloody.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.