The Sub Prime Fiasco: More Hype Than Fiasco?

Opportunistic politicians and the mainstream media, hyping a relatively inconsequential issue, made a mountain out of a molehill over the recent default in sub prime loans. The contention that the current global credit crunch is a major market meltdown is as absurd as rushing to the emergency room over a minor scratch.

The recent stock market fallout was more a result of investor fear than market fundamentals. Already, there are rumors emanating from Capitol Hill regarding the bailout of borrowers and lenders; borrowers regarded as too "ignorant" to realize they were unqualified for the loans and lenders distributing loans to borrowers who were so obviously unqualified. Questions of fraud are currently at the center of the controversy. Allegations of whether lenders proactively facilitated this fraud are under tremendous scrutiny.

Taxpayers should not be charged with the responsibility of bailing out the so-called victims of scandalous lending practices. Politicians, seeing an opportunity to further the benefit of their election campaigns, are suggesting additional regulations and further economic policy reform atop the barrage of regulations and policies already protecting our nation’s financial markets. Do you believe lenders did not already have in place policies that would prevent loss brought on by loan defaults?

Of course they did. However, sub prime lenders are in the business of risk-taking money lending. This is how it works: sub prime lenders consciously lend money to sub prime borrowers—those who would normally be under-qualified for a loan, hence the term "sub prime." In return, the sub prime borrower will pay the loan back at a much higher interest rate than prime lenders (those who normally qualify for a loan) and, in most cases, with balloon payments and much higher rates.

With all this considered, there is high risk for loss. Conversely, the bank receives huge returns if the borrower repays the debt. It is tantamount to a Las Vegas gamble in that if you gamble big, you win big and vice versa. The government does not subsidize those who lose big in Vegas or online gambling. Thus, a risky gamble can go bad at anytime.

Let us take a step back in time. Between 1998 and 1999, sub prime lenders were not only soliciting borrowers with extreme enthusiasm, they were bribing them with cash between $20,000 and $30,000. In essence, this was like handing borrowers free cash just for borrowing. Consequently, first time, second time, overly in debit and bad debt borrowers rushed the lines with no questions asked. This significantly helped ferment the largest housing boom in American history.

Between 2002 and 2003, borrowers/real estate owners gained surmountable equity vis á vis their property value. As a result, borrowers were enticed to take advantage of the myriad of home equity loan vehicles offered by lenders that inevitably forced borrowers into a spiral of debt. Banks, especially sub prime lenders, incessantly aroused borrowers, especially those living outside their means, with intriguing refinance offers. Again, lenders used "free" money as the gimmick. Gimmick lines, such as "refinance your home and receive extra cash," and "lower your monthly payments and receive extra cash," flooded the finance market.

Banks were practically stopping homeowners at the door offering the latest in home equity loans. Again, the lines formed and both borrowers and lenders were laughing their way to the bank. Moreover, they met year after year in order to refinance and receive more "free" money. Nevertheless, these borrowers would eventually have to repay their loans. Thus, their so-called free money eventually ran dry. And now the drought has arrived. Should this be a surprise?

Politicians and the media are attempting to tout the sub prime crisis as a poverty issue. However, it is an investment issue. Without the sub prime lending industry, high-risk borrowers would have no way to acquire homes, cars, and other large ticket items.

Opportunistic politicians are pushing for a taxpayer bailout. If you believe taxpayers should suffer the brunt of lender/borrower shortcomings, then I am living in the twilight zone. The market should be left to work itself out.

There is no crisis in the finance market despite the sub prime weakness. There will be a few failing institutions as a result, but it is not a meltdown. It simply means that financial institutions, over-extended in obligations, have succumbed to an issue of plain bad business. The ones that survive will be those that are diversified, investment-wise.

Sub prime loans, according to Forbes, comprise one percent of the $10 trillion mortgage industry. Of that one percent, 98.7 percent are being paid on time and 1.28 percent has been foreclosed (although many are catching up on behind payments).

According to an article by Jeff Bowyer of NRO Financial, Ben Stein, in an interview with Fox’s commentator Neal Cavuto, stated, "With approximately 254,000 mortgages in foreclosure at the moment—up from roughly 219,000 last year—the sub prime meltdown has given us an increase of 35,000 mortgage foreclosures over the last quarter. Since the average sub prime mortgage clocks in at almost exactly $200,000, we’re looking at an approximate $7 billion increase in foreclosed value in the first quarter of this year."

Cavuto asks, "How big is the household net worth in the U.S.? About a hundred dollars?" Stein replies, "Actually, it’s a lot bigger than that—about $53 trillion. In other words, the recent increase in sub prime foreclosures amounts to 0.01 percent of the net U.S. household wealth. That’s toothpicks!" Stein continues, "The dollar impact of the sub prime default is smaller than if it were a prime default."

In addition, Warren Buffet made an offer for Countrywide Financial for $21.80 per share, making August 21’s heavy gainers list. And recently, the Federal Reserve injected $38 billion into the sub prime sector to replenish liquidity into the market.  This persuaded foreign central banks to provide an additional $300 billion. This will aid both lenders and borrowers by providing them lower interest rates. Now may be a good time to add financial stocks to your portfolio for the short-term. As always, safe trading!

Joseph R. Chambers