The Subprime Tsunami

Here is the scenario: China is creating wealth at record levels.

Its central bank has invested more than $1 trillion in U.S. Treasuries and mortgaged-back securities. In fact, it is the largest investor in MBSs. The fastest-growing piece of MBSs has been subprime loans.

Years ago, Wall Street figured out it could make a mint off mortgages and began packaging them as fast as the Chinese were building high-rises in Shanghai. But the supply was constrained, so the Street urged originators to originate more home loans, as they had plenty of investors, including deep pockets from China (and Japan as well).

Then along came the minority/immigrant home-buying market as an opportunity. Promoting home ownership to this crowd became the rallying cry of President Clinton, President Bush, Congress, the Realtors, the home builders, mortgage bankers and the average bus boy who until now could not afford to buy a house.

It was an apple-pie bandwagon that no one could resist.

But how do you dig deep into this market unless you permit nothing-down loans, low-cost ARMs and loose underwriting? You can't. Hello subprime mortgage market.

Bingo -- it became the formula for the biggest property-ownership push since the Homestead Act.

The politicians fed off the phenomenon and the industry lapped up transactions. Sitting behind the curtain was Wall Street, of course, which made a boat load of money. Add careless underwriting on refinancings and credit lines and the money that came from China to help make more loans goes right back to the Chinese shores as consumers use their houses to buy depreciating assets like cars, clothes, toys and all sorts of stuff.

Now for the hangover: the upside-down homeowner.

Mortgage payments for many homeowners are doubling, inflation won't fill the gap, and many in this new class of homeowners are in trouble. Writing risky loans to unqualified home buyers is generally stupid. Inflation covered up the mess for awhile but not anymore. This summer much of this nonsense will come to a head.

It is like all financial scandals that involve Wall Street and real estate (remember the Savings & Loan crisis): there are severe consequences. Generally, consumers pay the cost of other people's gains. This is how the subprime tsunami works. The ocean recedes, people run to the beach and go WOW, then the big wave destroys them and the property behind them.

Is it really this dire? I hope not. What do you think?

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