Isn’t it amazing that those folks with bad or marginal credit (sub-prime borrowers) who had taken out 95%, or higher, percentage home loans with variable interest rates are now falling behind in their payments! Who would have ever expected that? Isn’t it somewhat akin to when ‘junk bonds’ collapsed and sank in value? Hello?? They didn’t call them sub-prime for any other reason that to put the world on notice that they were ‘highly marginal borrowers’, and they called them junk bonds because that is basically what they were … JUNK.
Who are the folks who ended up holding all these sub-prime loans and mortgages? They are: {a}investors who bought the ‘securitized’ real estate loans {loans ‘bundled’ into a package as backing for securities that were then sold}, {b} banks and other lenders who provided the mortgage/loan brokers with the ‘front money’ necessary to make and then inventory loans before they were ‘securitized’ or ‘bundled’ and sold to others, and {c} hedge funds who bought portfolios of sub-prime loans with borrowed money to leverage their investments.
The game has been to buy a $100 million sub-prime portfolio yielding a higher interest rate than the cost of the interest on the money that they borrowed to buy the ‘bundle’, thus enabling them to pocket the ‘spread’ in interest. Why were all these folks attracted to the sub-prime market? GREED. The interest rates paid by the not so bright and/or credit worthy borrowers were higher than those available on real estate loans made to more creditworthy borrowers. The age old practice of investment leveraging works only as long as {a} the money (interest) keeps coming in, {b} the underlying collateral remains solid, and {c} everyone ‘keeps the faith’.
How did all these sub-prime loans get made? You would have to have been living in a cave for the last several years to have not been aware of the non-stop radio, TV, newspaper and internet advertising directed at homeowners. Virtually all of these mortgage/loan hucksters have been offering ‘savings’ by offering home refinancing, or getting marginal borrowers into a home purchase, or providing money to buy real estate that was supposed to rapidly go up in value. Hello?? --- If you refinance and borrow more on your house and make variable interest-only payments for a longer term to lower your monthly payments --- exactly what are you saving? Further, if you refinance to pay off accumulated credit card debt, and then run up more credit card debt, isn’t all of this a self ordained death spiral?
What happened over the last 12 to 24 months is that the rapid escalation in real estate values cooled, prices have come down, while interest rates have been going up, and the inevitable and predictable is taking place. Those who bought speculative properties now owe more on them than they are worth. They can’t even rent them for enough to cover the debt service. Compounding this is the fact that the public fell in love with the lower initial interest rates offered by variable rates and gobbled them up by the billions. As interest rates have risen, so have their payments, and now they are having to ‘pay the piper’. Another part of this mix is the creativity of loan brokers who created ‘no doc’ loans --- meaning borrowers did not have to document their income, finances, or other debt and merely had to fill out loan papers. A final measure of crisis was then added with recent revelations of aggressive loan brokers altering borrower applications in order to ‘ram them through the system’ to earn commissions.
Now just about everyone has lost faith in the system and is starting to realize that the real estate loan collateral behind the securities that have been issued, and the loan portfolios that have been pledged as collateral, are worth a lot less than everyone was told, chose to believe, or expected. The house of cards is imploding and banks, hedge funds, investors and other lenders will no longer lend on, or purchase, these ‘less than prime’ real estate loan portfolios. This means loan brokers’ employees are being fired at a high rate as loan processing grinds to a halt, and many of the industry’s players look at bail out acquirers, bankruptcy or dramatically downsized operations as a means of either liquidation or survival.
You know that things are tough (and getting closer to the end of a cycle) when you read and hear about pleas for the government to bail out the idiots who have been trapped by their own GREED and STUPIDITY --- referring to virtually all of the players, including the borrowers, the loan brokers and those who chose to believe that there really was a free lunch!
What does all of this mean to you and I as the owners of privately owned businesses? It means that money is tightening and credit standards are going to be more restrictive for all types of loans, financing and leases --- not just for real estate loans. The CYA phase of the sub-prime aftermath will be litigation, some firings and everyone in the credit world requiring more documentation and perhaps a tad higher rate of interest. It also means that the Fed will most probably reluctantly have to lower the cost of money, earlier than otherwise might have been the case.
If you happen to own a well financed and managed business, there is a silver lining to all this madness. These events will most probably not negatively impact the economy in the intermediate or long run, but will make life much more difficult for our under capitalized and poorly managed competitors! You will also find that if you are about to implement an exit strategy, both the value you receive from your business and the financing for your buyer will probably be unaffected by the interim sub-prime fiasco. Further, if you have prudently accumulated capital, you will find that the coming months will provide you with some outstanding opportunities to add to or start a portfolio of residential rental properties that can be acquired at very favorable prices and accommodating financing from the banks who will be doing the foreclosing.
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