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Corporate & Securities Law

: Wall Street Law Blog

The foreseeability of subprime disaster

By Brett D. Sherman

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Subprime's fate was sealed from the start

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By Brett D. Sherman; The Sherman Law Firm

Subprime lending on a massive scale always had a limited shelf life. The only reason it worked at all was an unprecented and clearly temporary confluence of conditions:

(a) First, interest rates were at or near record lows and credit was plentiful and Wall Street saw the securitization and sale of subprime mortgage-backed securities as an ATM; (b) Second, home prices were rising at an incredible clip meant skyrockting home equity, so poor credit homeowners could refinance again and again rather than default; (c) Third, under pressure from Wall Street, subprime lenders offered new "affordability" loans -such as ARM's with ultra-low teaser rates that adjusted to much higher rates after two to three years; (d) Fourth: when, by 2005 or so, the "supply" of able borrowers ran low, lenders - again pressured by Wall Street - made low or no document "liar" loans available to just about anyone.

Wall Street knew the conditions could not last for too long, and they didn't. In a dynamic economy, stock values rise and fall, inflation rises and falls, and interest rates rise and fall. The housing market itself is famously cyclical. In other words, the odds of interest rates remaining at or near historic lows and housing continuing to boom for more than a few years at the most were pretty close to zero. If you think your local lender or investment bank didn't grasp this very basic idea, think again.

When interest rates rose - as they eventually had to do - adjustable rate mortgages held by so many subprime borrowers adjusted right on up with them. This was a major problem for those who could just barely afford their mortgage payments at the original payment level. The potential saving grace was the home equity (which provided an additional source of cash) that homeowners enjoyed as a result of skyrocketing house prices. Of course, many subprime borrowers - often encouraged or cajoled by subprime lenders - had already borrowed against this equity to do things like put in swimming pools, remodel the master bath, and install home theaters. These folks didn't have very much equity, if any, to draw upon when interest rates started to spike.

Then, the predictable endgame. As interest rates kept right on rising, the pace of the booming housing market began to slow. Then home prices flattened out. Then, in most parts of the country, prices started to dip. Goodbye equity. Hello subprime defaults. And more defaults, and even more. So long to the value of mortgage-backed securities, especially those backed by subprime mortgages.

The death of subprime wasn't just predictable, it was a sure thing. So why didn't the public - or even sophisticated hedge fund managers get it? Because the whole enterprise was a scam, a con, and the people running the con - from lenders to investment bankers - had a vested interest in keeping the process as mysterious as possible.

At that, they unfortunately were quite successful

For more information, visit our Website:

www.shermanlawyers.net

Full post as published by Wall Street Law Blog on May 04, 2009 (boomark / email).