The Subprime Crisis is Just Starting
Daniel R. Amerman, CFA
Overview: As the author of three books on mortgage finance and related derivative securities, and speaking as someone who first turned mortgages into rated securities in 1983, I’m going to let you in on an unfortunate little secret – the real subprime mortgage securitization crisis may not have even started yet. But, there is a good chance the real crisis will arrive soon.
This assertion that the crisis could just be getting started may seem absurd and extraordinarily out of touch. What about the approximately 45,000 homeowners losing their homes to foreclosure in the United States every month? What about the 8.9% plunge in nominal housing prices in 2007, the largest decline in over 20 years? What about Bear Stearns losing 94% of the value of its stock in 2 days, with even the remaining 6% in value being based on an unprecedented loan from the Fed before JP Morgan would agree to the acquisition? How much worse could it get?
To understand the full extent of the danger requires moving beyond current headlines to take a brief and simple look at how mortgage securitizations actually work. These securitizations are based on what are known as “stress tests”, or the ability of a security to withstand an adverse economic change and still pay principal and interest on schedule. The heart of the subprime problem is that no major stress tests happened in 2007 – and the market still blew up. Which brings up the question of what will happen to subprime and other mortgage derivative securities in 2008 if actual stress tests do occur in such possible forms as recession, increases in interest rates, or a further plunge in housing values? Given that the safety margins have already been stripped bare? As we will explore, should one of those stress tests occur – or worse, if two or three occur together – then we may look back at 2007 as being a mere stroll in the park in comparison... www.financialsense.com
