Where did the sub-prime money go?

[cannon_fodder]

What follows is my own little un-researched rant.  Please correct me if my ideas are totally off-base, but in trying to answer the topic question I came to the conclusion that the money is still here, in the United States.

1. Joe Alpha buys a house for $100K and takes out a note.  

2. He sells the house to Joe Blow for $200K, who takes out a note and pays Alpha the $200K who pays off the note and has $100K left over in cash.

3. Blow sells the California bungalow a week later to Charlie for $300K, pays off his note and walks away with $100K.

4. Charlie sells to Dick for $400K and walks away with $100K.

5. Dick takes out a sub-prime loan at 15% ARM with 0% down at Echo Bank.  

6. Echo sells half of that note to F Bank of England (simulating some notes getting bundled and sold over seas, not parts of a note I realize) and part of the note to USA Bank - taking a current profit on a future annuity.  

7. Dick defaults on his note.  The property is liquidated for $340,000 (the worst markets are off 15%).

8-A. Leaving  USA Bank and F Bank each out $30K (60K loss) and Dick out some incidentals (and a house which he didn't really own).

8-B. In actuality the notes are wrapped in securities and indistinguishable.  The result of the foreclosure is a reduction of the value of the entire note, due to poor record keeping (in the bundling) and panic the overall value of the note might be off more than 15% and it's liquidity compromised.  But the underlying value remains.
- - -

At the end of the day, this pyramid scheme resulted in a gain of $240,000.  In real life, very similar gains were seen over the course of the 10 or 15 years running up to this crash.  Each seller gaining and walking away with cash.  The last buyer really only lost out on any money he had put in - which was usually a zero equity line anyway, which made it similar to paying rent on the property.

So we leave F Bank and USA holding the bag for the 15% drop.  But over the course of the rise they made far more than 15% on the transacting real estate market AND about half of the sub-prime loans have been sold over seas.  The resulting build up and cash flow has left trillions of dollars in the hands of home selling Americans.

So when you hear that XYZ French bank lost $7,000,000,000 - that money is now in the United States.  A small bit of it is with E Bank for selling the annuity and the rest of it is in the hands of the prior seller(s).  The last one holding the bag - the largest financial institutions, have taken the hit.

(of course, those idiots sold their house and took their profit and drove it into a new house because of our tax laws and probably lost their house in an ARM, enriching that seller)

[spoonbill]

That's about how it worked out.  I can find any holes in that structure.  

For the most part it was a pyramid of stupidity.  I would like to think of it as "economic natural selection."

[FOTD]

The worst markets are down more than %15 (that's also a disproportionate average) but the example is good.

I would not make a huge issue out of the mess in sub prime. It's spread out. But I still am concerned about future inflation as a result of the excess of money being printed. And those that can least afford it are the victims here. Not the security holders.

The Saudi's told Bush the price of oil would be $30 not $90 if he had protected the dollar. And poor Georgie couln't do that and prop up Wall Street simultaneousy.

The trouble of fat and lazy is the problem with our attitude as a nation. The nation is of pigs. Lazy and incompetent. It's reflected in the manner in which we run our economy based on self satisfaction and stuff while not going for higher standards of morality.

It's all bound together. And our leaders continue to play into the self perpetual selling out to China and the Arabs.

[YoungTulsan]

That money is now circulating around the economy, creating inflation.  Some financial institutions are in a cash crisis since people are defaulting on their loans instead of making their payments - which would have pulled that new money back out of the economy and given it to the lenders.  Instead of getting the full amount of the mortgage plus interest, they are only getting back whatever they can auction or sell the house for (which just took a sharp turn downward during the bubble burst).

So the Fed's system of creating new money wouldn't have been too damaging to the economy if people were making their payments and streaming that money back to the lenders.  But in this collapse, much of that money is spilling out into the general economy causing inflation.

The lower class who had nothing to do with the housing bubble still gets to deal with the inflated prices caused by the money supply growing.  Manufacturers of construction materials profitted greatly from the fed artificially fixing the price of loans at a low point.  At some point, the production and investment surpassed a sustainable point in reality, since the availability of credit was SET to a cheaper level than the market would have otherwise set it at.  Now, everything has to unravel for a while and get back in tune with reality.

[Conan71]

Cannon, the only thing I don't see accounted for is all the interest paid by the subsequent owners in your scenario.  I'm first to admit I'm a little slow on big-picture economic theory.  Hell you may have even said it and I just glossed over it.  At some point it goes beyond accounting logic which I get easily and goes off into the algebraic which I've always struggled with.

As everyone knows the bulk of the interest is paid in the first 1/3 to 2/3 of a mortgage note.  For the first third, unless you are making extra principal payments, progress is dreadfully slow on the balance.

Let's assume Dick who paid $400K for the home lived there and made timely payments for four years.  Dick was paying in the neighborhood of $2000 per month in interest.

Let's round it off there for ease of calculation.

That's $96,000 in interest paid.  The investors/lenders took a $60K hit on prinicple.  Let's assume with legal costs of the foreclosure and other associated costs of preserving the property- add $10K.  They still gained $26K on the original $400K.  So is that really still a loss?  Granted that's pretty crappy return on a four year investment, but it's still not a net loss.  Let's say he defaulted on a five year interest-only baloon because he couldn't re-fi on the day of reckoning.  He would have paid $120K in interest in that case.

See where I'm going with this?  

We don't even know how many of these foreclosures are five year interest-only baloon notes.  The idea behind these were for flippers who were playing an inflating house market or people who assumed the market would have kept going and/or they would be earning more in five years and could handle more payment.  Now they can't re-fi because the house won't appraise at the principal balance, and they don't have the money to pay it off.

[HazMatCFO]

quote:Originally posted by cannon_fodder

What follows is my own little un-researched rant.  Please correct me if my ideas are totally off-base, but in trying to answer the topic question I came to the conclusion that the money is still here, in the United States.

1. Joe Alpha buys a house for $100K and takes out a note.  

2. He sells the house to Joe Blow for $200K, who takes out a note and pays Alpha the $200K who pays off the note and has $100K left over in cash.

3. Blow sells the California bungalow a week later to Charlie for $300K, pays off his note and walks away with $100K.

4. Charlie sells to Dick for $400K and walks away with $100K.

5. Dick takes out a sub-prime loan at 15% ARM with 0% down at Echo Bank.  

6. Echo sells half of that note to F Bank of England (simulating some notes getting bundled and sold over seas, not parts of a note I realize) and part of the note to USA Bank - taking a current profit on a future annuity.  

7. Dick defaults on his note.  The property is liquidated for $340,000 (the worst markets are off 15%).

8-A. Leaving  USA Bank and F Bank each out $30K (60K loss) and Dick out some incidentals (and a house which he didn't really own).

8-B. In actuality the notes are wrapped in securities and indistinguishable.  The result of the foreclosure is a reduction of the value of the entire note, due to poor record keeping (in the bundling) and panic the overall value of the note might be off more than 15% and it's liquidity compromised.  But the underlying value remains.
- - -

At the end of the day, this pyramid scheme resulted in a gain of $240,000.  In real life, very similar gains were seen over the course of the 10 or 15 years running up to this crash.  Each seller gaining and walking away with cash.  The last buyer really only lost out on any money he had put in - which was usually a zero equity line anyway, which made it similar to paying rent on the property.

So we leave F Bank and USA holding the bag for the 15% drop.  But over the course of the rise they made far more than 15% on the transacting real estate market AND about half of the sub-prime loans have been sold over seas.  The resulting build up and cash flow has left trillions of dollars in the hands of home selling Americans.

So when you hear that XYZ French bank lost $7,000,000,000 - that money is now in the United States.  A small bit of it is with E Bank for selling the annuity and the rest of it is in the hands of the prior seller(s).  The last one holding the bag - the largest financial institutions, have taken the hit.

(of course, those idiots sold their house and took their profit and drove it into a new house because of our tax laws and probably lost their house in an ARM, enriching that seller)

Reads almost exactly like the Texas real estate flipping schemes of the 80s that busted the state's real estate values and the S&L business in the late 80s.

That took about a $ trillion hit to the US treasury. This current sub-prime is on a wider scale so who knows how much it's going to take now.

[FOTD]

^Nope. Back then inflation was running double digits as was the prime rate. The S+L industry had a different set of regs back then from banks.

We have a much different set of circumstances today which is setting the country up for a bigger fiasco further down the line. By then, it will not be the Busheviks fault. And the dumbed down dems just made it so it's gonna be their fault for playing into the bad hand being dealt.

A more fundamental problem than sub prime.....breaking of the American Labor Unions by Raygun. Their motives caused standards of lending to deteriorate. The process also added to the downward spiral of the family unit as two incomes became neccesary to raise a family. In 1990, a $35,000 salary had to increase to $125,000 income today to keep up. Americans, especially their leaders, are fat and lazy idiots.
http://coanews.org/video/us-recession-the-result-of-decline-in-middleclass-wages

[YoungTulsan]

quote:Originally posted by Conan71

That's $96,000 in interest paid.  The investors/lenders took a $60K hit on prinicple.  Let's assume with legal costs of the foreclosure and other associated costs of preserving the property- add $10K.  They still gained $26K on the original $400K.  So is that really still a loss?  Granted that's pretty crappy return on a four year investment, but it's still not a net loss.  Let's say he defaulted on a five year interest-only baloon because he couldn't re-fi on the day of reckoning.  He would have paid $120K in interest in that case.

See where I'm going with this?  

We don't even know how many of these foreclosures are five year interest-only baloon notes.  The idea behind these were for flippers who were playing an inflating house market or people who assumed the market would have kept going and/or they would be earning more in five years and could handle more payment.  Now they can't re-fi because the house won't appraise at the principal balance, and they don't have the money to pay it off.

In your example, I'm guessing approximately 5.5 interest on a 30 year loan.  400K in new money was created.  After 4 years, he has paid $96,000 in interest and perhaps $12,000 in principal (guestimate).  So the bank got back $108,000 after it cut a check for $400,000.  It had hoped to get over $800,000 back over the life of the loan.  At this point, if it could sell the house for $300,000 there would be room to break even.  I don't think this situation is extreme enough to be causing the problems that are going on right now.

A more extreme example would be someone who forecloses in a little over 2 years after he takes out the mortgage.

I really don't have a lot of experience with the mortgage lending industry, I am just seeing if I understand the economic theory behind whats happening here.  Follow me and let's see if I understand how this works.

Let's say "Jimbo" takes out an adjustable rate mortgage on a $400,000 home that he could barely afford, but he was assured prices were only going to go higher.  He buys into the dreams that his $400,000 home would be a $500,000 home within a couple of years.  Jimbo buys his new house from its previous owner, Vinnie.

Let's call it Summer of 2004.

The data I am looking at says that the prime rate went 2% higher by the summer of 2005, and 2% more by the summer of 2006 (from 4.25 in July 2004 to 8.25 in July of 2006).

A 2% jump in your mortgage rate translates to nearly a 20% jump in your monthly payment.  And for people who got into loans they didnt need EVEN at the lower rate, they are in trouble.

- Subplot

Part of the problem with the housing bubble included lenders approving people for loans without any solid proof of their income.  An eager salesperson could help an applicant "fudge" the numbers a little bit, maybe exaggerate just a bit, so they could qualify, he could get his bonus, and the lender can make a sizeable closing fee.  Once interest rates started rising up from their artificially low points set by the Fed from 2001 to 2003, that is when the lenders got extra desperate and extra tricky.  It was a mad dash to approve as many loans as possible for the people that were merely profitting from the closing costs and commissions.

- Back to the main story

Flash forward to 2006, and Jimbo is hit with a mortgage that has adjusted to a payment around $1,000 per month higher than it was just over a year ago.  He could barely afford the original payment, and thought things would be better by now.  But he can't afford his payment anymore.  By the time he comes to the harsh realization that he can't afford his home anymore, people everywhere around him are foreclosing as well.  Going by CF's data that the "market" is down by 15% in bad areas, his home is only worth $340,000 now.  Incidentally, he has paid just a little over $60,000 in interest (and a teensy bit of principle) in the two short years he occupied this home.  He doesn't have the ability to cover a $50k to $100k gap if he were to attempt to sell his home for that much less than he owes on it (still nearly the full 400 large).  He stops sending money in, and forecloses.

Despite what you say about the "value" of the home being down 15%, if the market is flooded with foreclosures, it would be very difficult for the bank to turn that house back around for $340,000.  The bank has no intention of hiring a top dollar realtor to advertise the home and wait 6 months to a year to get the "market" 340,000 for the home.  Infact, the bank is desperate for money at this point, with all sorts of payments not coming in.  So they are in a situation where they put the house up for auction.  The house goes up for auction.  Let's say they are lucky and get 200,000 in the auction.  So in 2004, they cut a check to the previous owner Vinnie for $400,000.  Jimbo paid them about $60,000 before he realized he was screwed and gave up the fight.  They lucked out and got $200,000 back quickly from the auction.  They still gave out $140,000 that they never got back.  That is now money that has potentially spilled out into the economy.

The original owner, Vinnie, was just holding on to the property as an investment as he watched prices climb.  In 2004, at $400,000, Vinnie felt the time was right to cash in his investment.  Vinnie gets to convert his inflated home into whatever he wishes.  Vinnie just happens to be the patriotic consumer that Bush is encouraging all of us to be, so he buys some cars, electronics, and lives extravagantly.  That INFLATED money, new money created, is now circulating into the economy.  There is now more money out there, thus bringing down the value of ALL money by just a little bit.

Now, on the downside of this bubble, what WAS an inflation of HOME prices shifts into the general economy as inflation of CONSUMER goods.  Meanwhile, the financial institutions are in a money crisis trying to bridge the gaps caused by people not making their payments, and them not being able to liquidate their assets for nearly as much as they loaned out to begin with.  It all happened over the span of a few years.

The problem was that, in 2001, the folks in power decided we didn't want to have a recession and correct the market manipulations that had gone on prior to 2001.  The Fed made money cheaper to borrow, and the problem was pushed back a few more years, and into another market: the housing market.  This "prosperity" was prolonged long enough to keep the Bush admin in power during 2004, then interest rates started coming back up.  During the rise back up is when lenders started to become increasingly irresponsible, because the lending spree was almost over.  The mad dash to approve as many loans as possible caused the foolishness in subprime lending.  By 2006 it started falling to pieces.  Now, in 2008, we still do not know exactly how far reaching this situation really is.

Now the folks in power want to create $150,000,000,000 in new debt, and hand it out to the people hoping they go out and consume more.  Meanwhile the Fed is making money cheaper to borrow.  They are trying to fight off a recession that the economy NEEDS to get everything back in line with reality.  They swept it under the rug in 2001.  Now they are trying to sweep it under the rug in 2008.  The futher we go without having a full correction to realistic valuations in all markets, the bigger risk we have of a HUGE collapse that leads to DEPRESSION, not recession.

[FOTD]

January 26 / 27, 2008

The Profile of a Third World Country
How Bush Destroyed the Dollar
By PAUL CRAIG ROBERTS

It is difficult to know where Bush has accomplished the most destruction, the Iraqi economy or the US economy.

In the current issue of Manufacturing & Technology News, Washington economist Charles McMillion observes that seven years of Bush has seen the federal debt increase by two-thirds while US household debt doubled.

This massive Keynesian stimulus produced pitiful economic results. Median real income has declined. The labor force participation rate has declined. Job growth has been pathetic, with 28% of the new jobs being in the government sector. All the new private sector jobs are accounted for by private education and health care bureaucracies, bars and restaurants. Three and a quarter million manufacturing jobs and a half million supervisory jobs were lost. The number of manufacturing jobs has fallen to the level of 65 years ago.

This is the profile of a third world economy.

The "new economy" has been running a trade deficit in advanced technology products since 2002. The US trade deficit in manufactured goods dwarfs the US trade deficit in oil. The US does not earn enough to pay its import bill, and it doesn't save enough to finance the government's budget deficit.

To finance its deficits, America looks to the kindness of foreigners to continue to accept the outpouring of dollars and dollar-denominated debt.

The dollars are accepted, because the dollar is the world's reserve currency.

At the meeting of the World Economic Forum at Davos, Switzerland, this week, billionaire currency trader George Soros warned that the dollar's reserve currency role was drawing to an end: "The current crisis is not only the bust that follows the housing boom, it's basically the end of a 60-year period of continuing credit expansion based on the dollar as the reserve currency. Now the rest of the world is increasingly unwilling to accumulate dollars."

If the world is unwilling to continue to accumulate dollars, the US will not be able to finance its trade deficit or its budget deficit. As both are seriously out of balance, the implication is for yet more decline in the dollar's exchange value and a sharp rise in prices.

Economists have romanticized globalism, taking delight in the myriad of foreign components in US brand name products. This is fine for a country whose trade is in balance or whose currency has the reserve currency role. It is a terrible dependency for a country such as the US that has been busy at work offshoring its economy while destroying the exchange value of its currency.

As the dollar sheds value and loses its privileged position as reserve currency, US living standards will take a serious knock.

If the US government cannot balance its budget by cutting its spending or by raising taxes, the day when it can no longer borrow will see the government paying its bills by printing money like a third world banana republic. Inflation and more exchange rate depreciation will be the order of the day.

Paul Craig Roberts was Assistant Secretary of the Treasury in the Reagan administration. He was Associate Editor of the Wall Street Journal editorial page and Contributing Editor of National Review. He is coauthor of The Tyranny of Good Intentions.He can be reached at: PaulCraigRoberts@yahoo.com
http://www.counterpunch.org/roberts01272008.html


(neo-con motto)
"reduce the size of the US government until it will drown in a bathtub of water". Nordquist

[we vs us]

A couple of glitches in the scenario:

-- presumably your first three buyers/sellers have plowed at least a portion of their profit into more real estate, so the $100k that each of them made isn't necessarily protected from the housing slump.  

-- home values are continuing to fall and the majority of ARMs out there haven't yet reset, meaning that this cycle will continue for awhile -- possibly into 2009.  Combine that with muuuuuch slower sales, and Echo liquidating it's foreclosed properties at 15% begins to seem pretty rosy.  

-- If liquidation of assets can't happen fast enough, then Echo Bank must rely on its own cash reserves to pay the loans which it has securitized and sold to USA Bank, and to F Bank.  Echo Bank, in the past, might have relied on a short or medium term loan from another lending institution to pay off its debts, in part to give it time to wait out price instability and to liquidate its assets, but since potential lenders can't tell what Echo Bank's assets are worth, they're much less likely to extend a loan.

-- so USA Bank and F Bank are seeing losses to their CDO investments (not to mention their own mortgage portfolios) but don't know how much, because Echo Bank doesn't know how much.  This is one reason you're seeing multiple write-downs from single lending institutions; no one really know who's holding the bag, and the entire thing is still unfolding.  At this point EVERYONE'S taking the hit and just keeps on taking the hit.

-- lastly, I can't see how the underlying value of the home remains.  An asset is only worth what others agree it's worth, not what you declare it to be.  Or, what it USED to be worth.  That's why investors were getting into the market in the first place:  perceived value was going up up up.

FWIW, one of the things that's been showing up more and more is the willingness of homeowners with negative equity to just walk away from their house.  One of the econ blogs I read (I can't recommend it enough; it's called
Calculated Risk), quoted BofA CEO Kenneth Lewis as saying:

quote: "There's been a change in social attitudes toward default. We're seeing people who are current on their credit cards but are defaulting on their mortgages. I'm astonished that people would walk away from their homes."

In other words, homeowners in the most vulnerable markets are SO underwater, that being foreclosed on is a better outcome than trying to get a refi.  This quick blog entry from the LA times makes the point pretty succinctly.

[cannon_fodder]

Wevus -

I agree with some of your assessments.  

1. Much of the money was plowed into more real estate.  But presumably into a nice property than that which they had just sold.  Meaning, at the end of the day, they are probably better off.

This has to assume that they did not go for broke and take out a Dick style massive ARM with zero down that they could not afford.  Which should not be the case, since they had $100K in profits to put down.

2. The trend will continue and worsen for a while.  But unless value actually reset the net impact will be a gain.  Keep in mind prices were up 400% in 15 years.  So even if they lost 50% of the value there would still be a net gain... the prior insanity clearly could not have continued.

3. The resulting credit crunch of a slower market is a more serious concern.  I am not arguing that it is not creating economic difficulties, I was merely pondering where the 'lost' money went to.  I'd need an entirely new thread to speculate on the inflationary and credit ramifications of a massive home lending slow down (I see some positives -> business loans and solid home loans should be more available).

4. Lastly, assets are only worth what people are willing to pay them.  The 15% drop in the California realestate market represented actual sales - it is what people are willing to pay.  I suspect that number will drop  a little more, but likely it will soon level off as people eat their losses and most actually live in their homes instead of flipping them.  This will result in a slow down of appreciation for a good number of years as prices slowly creep back up to their prior levels.
- - -

Conan:

I'm not arguing that people are not going to get screwed.  I'm basically saying the last person - the poor guy left holding the bag (the note, as it were) is the one that gets screwed (as is the bank).  The guy that sold him the house is just fine as he has cash in hand (assuming again, that he used his profits as a down payment as tax laws encourage).  

In my example, Dick would be out the horrible interest.  However, in many instances the $2000 a month in interest would be about equal to what he would pay in rent for a comparable dwelling.  So at that point it becomes just the cost of living in luxury (or in California, in a home).
- - -

YoungTulsan:

Great read.  You took my example and tied it into the current issue.  

Few doubt that the real estate market was not sustainable as the buyers bought more than they could afford, banks bought notes they did not understand, and brokers/realtors pimped whatever they could to get a commission.  Sorry, but they are all equally at fault.  A market correction NEEDED to happen and needs to continue. I'd like to see it slowed, but the $150Bil is a joke.

Why would the guy that makes $60K a year and bought a $300K house use his $1200 check to try to catch up?  Clearly the guy isn't financial responsible anyway.  Money we don't have so people can buy crap they don't need.
- - -

AOX: show me the secret discussion where the Saudi's told Bush he could have $30 oil if he held the dollar and I'll bother discussing it.
- - -

[FOTD]

Did the Saudi's do that? We'll never know. It's obvious though.

The Saudi's may have told Bush had he protected the dollar, the price would be much lower per barrel today. Surely they too know what an idiot government he's running where his people come before the American people.

[rwarn17588]

This is a theory I have with not a lot of evidence, except for some strong hunches.

The housing market slump is a complex situation. But I'm getting a strong vibe that there will be a lot of people indicted in the banking and appraisal industries on fraud charges.

Here's why I think so: About six months ago, I went fishing for a home equity loan among several banks for home improvements. One national chain bank that I ultimately didn't do business with appraised my home at a value that had risen 50 percent in just three years since I bought it. To say that my eyebrows went up is an understatement.

I live in an area that's nice and quiet, but hardly what I would call super-desirable. The more I've been thinking about it, the more I suspect something fishy has been going on between appraisers and/or banks. To see a house go up in value five times the rate of inflation seems crazy, especially when Tulsa was more of a slow-and-steady-growth real estate market. There seemed to be no earthly reason this should happen, other than someone cooking the books to try to give out loans.

Thoughts?

[cannon_fodder]

I agree with your idea.  I am confident that banks instruct appraisers to give a number they are comfortable with for whatever reason, not necessarily what the market price is.  This is an instance of the banks having too loose of credit/too much risk AND appraisers with no integrity (sure, I'll say it's worth whatever you want).

But it is probably NOT fraud.  Not in an actionable manner anyway.  At the end of the day you got your loan and the bank got it secured against you house.  Both parties agreed to the value and got what they bargained for - it's "true" value is not relevant.

[FOTD]

quote:Originally posted by rwarn17588

There seemed to be no earthly reason this should happen, other than someone cooking the books to try to give out loans.

Thoughts?

Yes, lenders want to make loans....it's their life blood. In cahoots? Definitely. Poor oversight seems to have brought this all on.

In the 80's, this region was "red lined" by lenders who knew the Feds were in here keeping close watch on terms, conditions and credit. In addition, local banks had no money to lend after the banking debacle precipitated by the drop in the price of oil, a big prime rate and practically no government supervision.