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Lorimer Wilson

Lorimer Wilson

Lorimer Wilson is Editor of www.FinancialArticleSummariesToday.com (F.A.S.T.) and www.MunKnee.com (Money, Monnee, Munknee!) and an economic analyst and financial writer.

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The August 2007 Panic - What Happened and Why

Just how long did the powers to be think they could keep this Ponzi scheme of mortgage debt going before it would begin to unravel? I first wrote about it in June, 2004 when I outlined in my article "Our Worst Nightmare - the Puncture of the Current Housing Bubble" how simple mortgages were being transformed into derivative instruments called Collateralized Debt Obligations which would become bad investments if either interest rates increased or housing prices fell to the extent that they resulted in an inordinate increase in mortgage defaults. Regretfully, that has indeed happened peeking out in February, showing its ugly head in May with the Bear Stearns fund blow-up and coming home to roost during the past month.

As the Globe and Mail reiterated in a recent editorial "the situation is largely the result of sloppy U.S. mortgage lending practices and disgraceful complacency by rating agencies and regulators alike over the past few years (and let's not forget the greed of all involved - lender, borrower and investor alike).

It all started when central banks, especially the U.S. Federal Reserve, kept their pivotal rates at low levels from 2003 to early 2006. Enticed by the prospect of cheap credit, the U.S. market in subprime mortgages (60% of which are adjustable rate mortgages - ARMs ) boomed as lenders handed out funds to people who did not qualify for market rates because of their questionable credit worthiness. Indeed, in 2006, the subprime mortgage market grew to represent an astonishing 47% of all new mortgages as lenders scraped the bottom of the lending barrel often simply asking borrowers to state their own incomes and accepting the answers without follow-up checks. (i.e.'liar loans'- see below)

When housing prices fell some subprime 'owners' found themselves with losses that were higher than the value of their house (while others could not make their monthly payments when their ARMs were reset as much as 25% higher than their original teaser rates given the fact that 60% of such borrowers, according to the IRS, overstated their incomes by more than half. As such, the math reveals that 30% of the loans made were to people who were stretching to buy a home and whose actual income would not qualify them for a home anywhere close to what they bought). It is no wonder that 60-day delinquencies on 2006 loans were 25% higher than those on 2005 loans.

The lenders, for their part, packaged those mortgages, along with higher grade mortgages, into securities packages called Residential Mortgage Backed Securities and sold them to eager buyers as Collateralized Debt Obligations (CDO). When the defaults escalated to a certain point (and research by RBS Greenwich suggests that 20 - 23% of all subprime loans made in 2006 will go into default and foreclosure causing losses of 10 -11.5%) it became clear the financial markets had grown lax in their pricing of risk and so, in the past two weeks, and to everyone's alarm, the price of risk has been recalibrated" and since there is a much reduced market for their CDOs those owning them (foreigners, mutual funds and hedge funds) have undertaken to sell their high quality holdings - stocks, commodities, etc - at reduced prices to meet margin calls. That explains why assets that do not normally correlate with each other have all moved together - down."

"As that stampede continues - as the market re-estimates the risk of key holdings - ordinary investors are seeing their savings diminish" says Don Drummond, the senior vice president and chief economist at TD Financial Group. "The question is - where do the markets go from here? Do they recover from this new, lower base with valuations that more appropriately reflect risk or does a self-perpetuating downward spiral become entrenched?

The bad news from the U.S. housing and subprime mortgage market is far from over in that, while the U.S. new housing market has likely bottomed out, there is still a dramatic inventory overhang of resale homes which will put further downward pressure on housing prices and could, in turn, bring more mortgage defaults and lower households' perception of their wealth and, hence, spending power. Furthermore, a lot of U.S. mortgages still have triggers that will raise the interest rate on payments later this year or early 2008. This pending bad economic news could be an argument that the market adjustments are not yet complete although these factors are well known and should have been reflected in the recent actions of the market.

The good news is that the world economy is sound and growth is running around 5% per year which is more than a percentage point above the long-term average. Even with some spillage from the U.S. housing market into other parts of the U.S. economy growth might only soften to around 2%. Previous episodes of credit crunches, such as in 1987, 1998 and 2001, had relatively happy endings and the underlying economic conditions were not nearly as favorable as now.

All in all, this episode could be seen as nothing more than a way, jarring as it has been, of restoring more reasonable risk premiums to the market. In my opinion, as information becomes more available on who holds risky assets and what, if anything backs them, we will see further relative market price adjustments with the exposed companies and countries being hit further, while the clean parties will see their asset valuations restored. Astute investors will recognize this as a buying opportunity."

Jeff Rubin, CIBC World Markets chief economist, sees solid growth in the global economy, good corporate fundamentals and possible rate cuts from the central banks which will, in hindsight, be seen as a buying opportunity for equities.

Harry S. Dent believes that the strong selling pressure in stocks, commodities, foreign markets and emerging markets shows that a strong buying opportunity is near and the downside risk is limited. He remains confident that the stock market will rally back to the recent highs because there is simply no place else for money to go now that real estate is clearly slowing and declining in some places, foreign markets are cooling and commodities are likely taking a substantial break due to the slowing economy. With earnings still growing he believes stocks are just the place to be, that a strong sustainable advance is just ahead, that the beginning of the next stock bubble is at hand, that the rally expected later this summer could be a great opportunity for savvy investors.

So there is it in a nutshell - what happened, how it happened and why it happened when it happened and what we can likely expect to happen in the near future. For those wanting a detailed clear understanding of how the whole debacle developed I encourage you to read John Mauldin's August 17th article entitled "The Panic of 2007".


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