Casey Files:
The Second Crash -
On the Way and Unstoppable
Doug Hornig
Editor, BIG GOLD
May 29, 2009
lovely early fall day, with the temperature still a balmy 80° at 2:00 in the
morning. By evening, though, the temperature had dropped twenty degrees, the
clouds had rolled in, there was thunder and rain.
As with the weather, there were some hints of trouble here and there
on Wall Street. But all in all, things could not have seemed better. Little
did we know, the stormy end of 10/9/07 signaled a very large bubble that had
just popped.
That was the day when the Dow Jones Industrial Average hit its
historic peak. From there, it was all downhill - slowly but steadily at
first, and then violently after last August - until the Dow bottomed (for
now) on March 9 of this year. Over that span, the index lost 54% of its
value.
It's been a crushing blow to just about everyone. But it's already
being referred to as the crash. As if the unpleasantness were now all behind
us. More likely, in the future it will be seen as, simply, the first crash.
Don't believe it? In a moment you will, when you see the scariest
graph of the year.
But let's quickly recall what's already happened. During the late,
great housing boom, interest rates were at microscopic levels, while bankers
were encouraged to grant home loans on little more than a wink and a nudge.
In order to inflate their balance sheets, those bankers resorted to all
sorts of gimmicky, adjustable rate mortgages (ARMs), whose common feature
was an interest rate that would eventually reset. That is, it would balloon
somewhere down the road. And those most likely to come quickly to grief were
the riskiest borrowers, who held loans known as "subprime."
"But not to worry," borrowers were told. "Betting on ever-rising home
prices is the safest wager in the whole wide world. If you have problems
with cash flow when the ARM resets, your house will be worth a lot more, so
you can simply sell it and walk away with a nice chunk of change in your
pocket." Uh-huh.
The bankers themselves were a little more concerned about the
deterioration of their portfolios. They took out insurance in the form of
credit default swaps (CDSs). These were a brand-new invention in world
financial history, allowing mortgages to be sold and resold until they were
leveraged 20 times over. They became the shakiest part of a huge global
derivatives market, with a nominal value in the tens of trillions of
dollars.
For a while, this Ponzi scheme even worked. But then, as they had to,
the ARMs began resetting, and there were defaults. Then more of them.
Because at the same time, the housing market was cooling off and the economy
was stalling out. More and more people were trapped in a situation where
they owed more on their home than they could sell it for. Many simply mailed
their keys to the bank and moved on.
All of this wreaked havoc in the derivatives market. Sellers of these
exotic packages could no longer establish what they were worth. Buyers
couldn't determine a fair price and so stopped buying. As the ripples spread
through the world financial system, trust disappeared and liquidity dried
up.
Now consider that the base cause for all that dislocation was the
subprime sector. And how big is that? Not very. Subprime mortgages account
for only about 15% of all home loans. Their influence has been way out of
proportion to their numbers, because of derivatives. Here's the good news:
the subprime meltdown has about run its course. These loans were resetting
en masse in 2007 and the first eight months of '08. Now they're pretty much
done.
And the bad news? No one in the mainstream media seems to be asking
what should be a pretty obvious question: What about loans other than
subprime? Truth is, the banks didn't just trick up their subprime loans.
ARMs were the order of the day - across the board.
Now, here's that frightening graph we referred to earlier.
Take a good, long look. You can see that from the beginning of 2007
through September of 2008, subprime loans (the gray bars above) were
resetting like crazy. Those are the ones people were walking away from,
sending a shockwave from defaults and foreclosures smack into the middle of
the economy. Now they're gone.
The ARM market got very quiet between December 2008 and March 2009,
hitting a low that won't be seen again until November of 2011. Small wonder
a few "green shoots" have poked their heads above ground. But in April,
resets began to increase and will reach an intermediate peak in June. After
that, they tail off a little, going basically flat for the next ten months.
It's not until May of 2010 that the next wave really hits. From there
to October of 2011, the resets will be coming fast and furious. That's 18
months of further turmoil in the housing market, and the beginning is still
nearly a year away! (Although the months in between are likely to be no
picnic, either.)
While it isn't subprime ARMs that are resetting this time, neither are
they prime loans. Those eligible for prime loans wisely tended to stay away
from ARMs in the first place, as indicated by the relatively small space
they take up on each bar.
No, the next to go are Alt-As (the white bars), Option ARMs (green)
and Unsecuritized ARMs (blue). Alt-As are loans to the folks who are a small
step up from subprime. Unsecuritized loans are a 50-50 proposition; either
the borrowers were good enough that they weren't thrown into the CDS pool,
or they were so risky no one would insure them.
Those two are bad enough. But Option ARMs are the real black sheep,
loans with choices on how large a payment the borrower will make. The
options include interest-only or, worse, a minimum payment that is less than
interest-only, leading to "negative amortization" - a loan balance that
continually gets bigger, not smaller. Imagine what happens with those when
the piper calls.
Once the carnage begins, will it be as bad as the subprime crisis?
That's the $64K question. Perhaps not. For one thing, subprime loans were a
much larger chunk of the market when they started going south. For another,
there's been a lot of refinancing as interest rates dropped; that should
help ease the default rate. And the government has massively intervened,
with measures designed to prop up those who would otherwise lose their
homes.
On the other hand, we're in a severe recession, which wasn't the case
when the subprime crisis started. More people will be unable to meet
payments. And the housing market has continued to decline, pressuring both
marginal homeowners and banks that can't sell foreclosed properties.
Is the stock market's next 10/9/07 on the way? Yes. Which day will it
be? That's unknowable. It could be in a week, or not for another year.
But make no mistake about it, the second crash is coming. It can't be
prevented, no matter what desperate measures Obama and his hapless financial
advisors come up with. All we can hope for is that, with a little luck, it
won't be as severe as the first one. But it will last longer. We aren't even
in the middle of the woods yet, much less on the way out.
The order of the day is to be very defensive. There will be few safe
havens, but they do exist.
http://www.321gold.
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