Subprime Blues

One of God's attendant's has passed judgment. "The punishment has been meted out to those who have done misdeeds and made bad judgments," Mr. Poole declared. "We are getting good evidence that the companies and hedge funds that are being hit are the ones who deserve it.''

One month before the St. Louis Fed President's declaration, Bear Sterns closed two of its hedge funds burdened by the debt of subprime sin; 10 day prior, that same company cut the credit ratings of $12 billion of subprime backed bonds. The B-paper crisis threatens to spill into the A minus range. On Monday, American Home Mortgage, a large lender to borrowers with Alt-A ratings, the credit standing just inferior to the highest possible, announced bankruptcy. American Home's decline was precipitous, with most of the selloff confined to this last week. In January of this year, its stock was brushing an all-time high.

The Monday market session shrugged off subprime woes to prey on recently devalued shares. Many, including Fed Chairman Ben Bernanke (God) and Treasury Secretary Henry Paulson, state that the troubles are unlikely to have significant ramifications. In their minds, unsophisticated borrowers and risk-thirsty lenders are paying the price of myopic decision making.

On Tuesday, the Federal Open Market Committee kept the benchmark rate steady at 5.25 percent. "A sustained moderation in inflation pressures has yet to be convincingly demonstrated," the FOMC members wrote. Although they noted ongoing stock market turbulence, their neutral language suggests that if we hold our breaths long enough, the hiccups will go away.

Certain visionaries foresee doomsday. That raving mad pundit, Jim Kramer, has started broadcasting his take on pessimistic insider scuttlebutt. Kramer's self-professed courageous moral stand insists that the Fed is turning a blind eye to obvious signs of economic distress. In a clip from CNBC, he breaks down. "He's nuts! They're nuts! They know nothing!" Right over the horizon lies 1987, 1990.

The heads are beginning to roll. On Monday, one of Bear Stearns's two presidents was kicked out in the wake of the dual hedge fund implosion. The Democratic Congress is issuing threats. "Use it or lose it," Barney Frank told the Fed, referring to their neglected consumer protection capacities. Federal inquiries into "predatory lending" will likely claim a few corporate victims in the coming year.

Meltdown in the subprime mortgage sector affects three main groups. Firstly are the borrowers of the loans. Subprime borrowers are defined as having weak credit histories, often including bankruptcy in the last five years, two or more 30-day debt payment delinquencies in the last year, or foreclosure in the last year. In Denver, a city hit hard by the crisis, one out of every 21 mortgages foreclosed in 2006. From 2005 to 2006, there was a nationwide 42 percent rise in foreclosures. This year, the increase is predicted to be another 33 percent.

A strong housing market postponed the disaster. Borrowers were able to refinance with their new equity. But as the market cooled and rates started resetting, the unlucky started facing untenable payment schedules. An estimated $265 billion of subprime mortgages are due to reset this year.

Suffering mortgage companies have desperately pulled in every outstanding line of credit, and loans are no longer forthcoming from financiers. Myriad lenders are cutting off their subprime mortgage arms. Today, Atlanta-based HomeBanc, Corp. announced the elimination of its entire mortgage business. Considering the number of companies that have taken similar action in the last year, there must be a sizeable number of newly unemployed.

As the borrowers started defaulting, Wall Street firms that owned pacakaged loans, called "collateralized debt obligations," took a share of the pain. The two defunct subprime-laden Bear Stearns funds folded after Merill Lynch hastily reclaimed $850 million of advanced credit.

A worrisome aspect of the whole matter is that Wall Street may lose its appetite for high-risk financing. How has the recent wave of buyouts been financed? Only partially through subprime debts; also through a wide range of other dicey tools. But in recent months, it has seemed as if leveraged buyouts are the only bull-baiters. If that action slows or ceases, from where will the stock market draw inspiration?