Behind the Subprime Crash

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Market
volatility in recent days prompts one to ask, “Just what is going
on here?”

The quick answer
is that Federal Reserve manipulation of the money supply causes
these crisis periods when previously available Fed money is no longer
available.

The long answer
requires a very winding explanation.

The Federal
Reserve, however, still plays a major role in the long answer.

The Federal
Reserve has been pumping new money into the economy for decades.
A lot of this new money, not surprisingly, has found its way into
the mortgage markets. With Wall Street’s “securitization
of the mortgage industry, close examination of mortgage borrowers
disappeared. Banks and mortgage companies had incentives to originate
mortgage loans, but since they sold the mortgages off (via securitization)
they had no incentive to carefully weigh the risks of individual
mortgages.

If you had
a warm body, banks and mortgage companies only had incentive
to figure out how to get you a loan. Bad credit, no problem. Can’t
afford to make monthly interest rate payments, no problem. Thus,
we had the era of “no docs” mortgages and “Adjustable rate” mortgages
with early year rates set sometimes at zero often times at 1%.

On the buying
end of these securitized mortgages were institutions with faulty
economic models. These models were quantitative in nature. As Austrian
economists have warned
many times, economics is a qualitative
science, not a quantitative science. This is so because the world
of human action contains no constants, when you are dealing with
humans everything is a variable. The models designed by these institutions
must therefore assume that some variable is a constant, since an
equation with all variables just can’t be.

Some of these
variables will indeed over very long periods of time “act” like
constants in their relationship with other factors and not change
much. These are the variables that econometricians plug in as constants
to design their equations. Every once and awhile one of these pseudo-constants
begins to act up and act like a variable again. At such time, the
variable will blow up the misplaced belief in the equation and quite
possibly blow up an investment portfolio or even an entire economy.
The designers and money managers who believe in these equations
are in fact playing “Equation Roulette." The blow-ups can occur
at any time.

The collapse
of funds like Long
Term Capital Management
(Equations designed by Nobel Prize winning
econometricians!) and the current hedge fund blow-ups (because of
subprime mortgage investments held) always collapse because variables
start to dance.

In the subprime
mortgage arena, the variables are dancing.

The equations
used as the data points of how mortgages would perform come from
the data from the decades of the 1980’s and 1990’s, before securitization.
So the models did not take into account the change in the way banks
and mortgage firms would change the types of mortgages they would
originate if they did not have to worry about the risk.

Thus, a market
of nutty mortgages, with no docs and, goofy ARM’s structures, developed,
one that only an econometrician with nutty equations in hand would
buy — encouraged by a Fed pumping money in so that real estate flippers
could hide the fact the mortgages were nutty.

Along this
happy road of Equation Roulette, before the subprime crisis started
to bloom, the government stepped in with small changes in some regulations
as to who could get mortgage financing. Naturally, the econometricians
in their models didn’t include for a change in regulations, but
this change in regulations started the subprime crisis. At the margin,
these regulation changes took out some of the real estate flippers.
For the first time in decades, there was a small decline in the
true number of real estate buyers.

The few smart,
more detailed oriented, buyers of subprime paper picked this trend
up and stopped buying the subprime paper. The Fed was still printing
money, it was just starting to be re-directed. The smarter players
just started to put their money into LBO’s and private equity deals
instead of mortgage securities.

The decline
in subprime paper buyers, coupled with the regulation changes, formed
the start of the subprime crisis in near perfect storm timing, since
these factors dovetailed with the first zero percent and 1% ARM
mortgages coming due for readjustment and the Fed notching interest
rates up a bit.

This was a
formula for disaster. Equation roulette was about to blow up another
batch of econometricians. As default rates climbed, more and more
subprime paper buyers backed away from the subprime market, until
we have reached the point today where there is near zero liquidity
in the subprime market.

The near zero
liquidity of these highly leveraged funds has resulted in margin
calls, panic, and some of these funds being forced to sell positions
in other sectors of the market. But, this crisis is near over. The
Fed has come to the “rescue." Just today it has pumped $19
billion in new reserves into the banking system by buying mortgage
securities. My rough calculation suggests that over the last two
days the Federal Reserve has pumped in enough new reserves to increase
the money supply by somewhere between 10% and 15%.

This is a stunning
number. The money supply in a year rarely grows by 10%, for it to
do so in 48 hours is mind-boggling. Yes, the Fed has come to the
rescue by further pushing the dollar on the road to collapse. While
most eyes are on the current mortgage crisis, the bigger danger
is the potential collapse of the dollar on foreign exchange markets.
The dollar has been slowly falling in value against most currencies
for a while. It is at multi-decade lows in some cases. I have feared
a further major collapse of the dollar even before the Fed’s moves
over the last two days.

The mortgage
crisis will pass. The Fed will print its way out of this crisis.
But, the dollar crisis is ahead and the Fed won’t be able to print
its way out of that since it’s been Fed money printing that is the
cause of the world being flooded with dollars.

From the outrageous
money printing that fueled the mortgage “boom” to the Fed “rescue,"
the Fed step by step is setting up the economy for inflation and
a crash of the dollar that won’t just affect mortgage holders and
hedge funds, but anyone holding deteriorating dollars in their bank
accounts and wallets.

August
11, 2007

Robert
Wallach [send him mail]
is editor and publisher of EconomicsBriefing.com.

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