I recently read a great article in CondeNast Portfolio that does a wonderful job of connecting the dots in the subprime lending meltdown.
The market storm has already taken out the CEOs at Citigroup and Merrill Lynch, which mostly just serves to frame the fact that the turbulence isn’t limited to some lending backwater, but rather that it has upset the apple cart on Wall Street.
As the argument goes, the real pain is destined to be felt on Main Street at the consumer level.
While I am not a pessimist, and am actually pretty positive about the level of productivity gains and innovation domains that are upon us, I do recognize a couple of storm clouds that are forming.
One is that it is easy to foresee a scenario where higher interest rates result when increased loan default rates drive the need for greater risk premiums (for lenders to lend). There are a lot of variable rate loans out there, and especially those with artificially low teaser rates, are going to endure some pain.
Two is that you start to see how a liquidity squeeze (where lenders just don’t lend to large categories of would-be borrowers) could be pretty crippling to our economy by breaking a lot of models that assume ready access to expansion capital.
Three is how much of consumers’ exercise of wealth has been driven by equity expansion as the price of (their) homes boomed. It will be interesting to watch how the inverse of this behavior plays out as their equity contracts.
Having lived and worked through the build up to the tech bubble and its subsequent burst, I can tell you that some kind of hangover is inevitable.
As a storyline with a narrative, though, it is pretty fascinating. You take for granted the types of loans that were made to people with poor credit histories, those with no verified sources of income and those making ridiculously small down-payments. Few appreciate the importance of the secondary marketplace in creating liquidity. In some markets, it is just astounding the role that speculators played in absorbing inventory (the same dynamics played out in the tech bubble).
And when you understand the role that the rating agencies played in metaphorically dipping in holy water the derivatives created from portfolios in high risk loan categories and anointing them as "investment grade," it is an AHA moment.
Here are a few nuggets from the article:
Think of the current situation as a deep-sea earthquake. The plates shifted late last year when home prices in the U.S. stopped rising.
The housing boom didn’t merely inflate home prices. Home equity extraction has accounted for as much as one-third of consumer spending growth at points during the boom.
John McCain has been reciting a quote attributed to Chairman Mao: “It’s always darkest before it’s completely black.” That may be where we sit now. In August, we had a credit panic akin to a run on the bank, but on a global scale. Even companies that had made mostly safe loans—like Countrywide, the nation’s largest mortgage lender—found that the short-term-borrowing markets were closed to them.
Companies unrelated to the mortgage market will find credit tighter as banks divert cash to cover their bets. Trades and investment strategies that relied on the cheap-money boom will unwind.
The skittishness, however, was a symptom of larger imbalances—in the dollar, in global trade, and in American consumer debt.
But read the full article. It is great.
RELATED LINK:
- NY Times article, 'What Created This Monster' adds some further analysis.
There is a thought-provoking interview at The Motley Fool with Blockbuster’s new CEO. 
