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Subprime Collapse: A Simple Guide

Posted January 2, 2008

"Starting from a virtual standstill 10 years ago, subprime lenders became by far the fastest-growing segment of mortgage lending. They wrote US$540 billion in mortgages by 2004 and US$625 billion at their peak in 2006 - roughly one-quarter of all new mortgages." — John Pugsley.

Blogger's note: Our friend John Pugsley at The Sovereign Society sent us an excellent article on the subprime debacle. And I thought you'd appreciate a look. You can find the entire article here or read on for more information below.

by John Pugsley

Baltimore — (TFN): It's a perfect time for wise investors to reflect on the past year, and the lessons 2007 brought. However, to really understand the turmoil in stocks, bonds and real estate of these past 12 months you must understand the roots of that turmoil.

Those of us who lived through the financial storms of the 1970s remember inflation peaking at 18%, and interest rates tracking them closely. Paul Volcker took over the helm of the Fed in August 1979 as the inflation crisis raged.

Volcker Veers Us Towards Prosperity

Rather than letting the U.S. plunge into hyperinflation, Volcker did the right thing: He put the brakes on money creation. It worked, and inflation subsided. Then, to prevent the recession from turning into a depression, he changed course and began to ease in 1981.

Between January 1981 and 2004 the Federal Funds rate bounced erratically downhill. The Fed Funds eventually fell from its high of 20% to a low of just 1% in 2003. It was a rate not seen since 1954, 50 years earlier.

The Fed's relentless credit expansion over this past quarter century had predictable effects: Price inflation…no, not price inflation of consumer goods. Strangely, this vast money expansion didn't show up it the CPI. Rather, it created a boom in asset prices.

Stocks, real estate and even art seemed destined to rise forever, and investors' expectations skyrocketed right along with them. It seemed a new era of endless prosperity had arrived.

In the Age of Alan

As the 21st Century began, now with Alan Greenspan at the helm, credit was flowing, and stocks and real estate boomed.

Using the global supply of dollars as a proxy, The Economist estimated that liquidity had risen by an annual average of 18% in four years. The Economist said it was probably the fastest pace ever. Worldwide, an abundance of easy credit lured investors into riskier assets for higher returns.

Real estate became the investment darling. Now, every American could become a homeowner. If you didn't quality for regular mortgages, you could turn to the new subprime lenders.

Starting from a virtual standstill 10 years ago, subprime lenders became by far the fastest-growing segment of mortgage lending. They wrote US$540 billion in mortgages by 2004 and US$625 billion at their peak in 2006 - roughly one-quarter of all new mortgages. By late 2005, the battle for market share had pushed rates for borrowers with poor credit down to a little over 7%.

Subprime Lending Starts to Unravel the Economy

Fast forward to this past January. As 2007 began, the unintended consequences of the credit surge began to appear. In December a number of mid-sized mortgage firms failed. The first was Ownit Mortgage Solutions, the 17th-largest subprime lender. Owners of other subprime lenders put their businesses up for sale soon after to flee the business… Read on here to find out how far subprime fallout will extend and how to protect your investments from the crash.

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