Causes of the Mortgage Meltdown

What has occurred in the credit and real estate markets are unprecedented. While on the surface the news is bleak, it is times such as these where opportunities are born.

In our estimation, the recession that will shortly be announced began surfacing in mid 2007. When economists look back a year from now they will probably determine that the 2008 recession actual began in January.

The heart of the problems gripping the financial markets begins and ends with the feeding frenzy we saw in real estate, risky exotic loans, and sub prime loans that should never have been made. Here's how it all began;

1) In 1977 the U.S. Congress passed The Community Reinvestment Act (CRA) which required banks to loan money to people with poor credit, bad credit, low income, and a segment of population that has showed no fiscal discipline.

In 1995, Bill Clinton and his administration strong armed the banks and lenders to follow the Community Reinvestment Act or face severe consequences by regulators. Revisions made by the Clinton Administration to the CRA in 1995 were one of the main causes for sub prime mortgage crisis. This is so outrageous that I am lost for words.

The sub prime loans issued by banks and lenders are a direct result of the Community Reinvestment Act. Once these loans were made, they were repackaged as investments, and sold to investors.

The source that I quoted above on the food and energy situation is intimate with the banking industry. Here are his comments on the Community Reinvestment Act comments I made above;

Over 80 percent of sub prime mortgages were originated by entities not subject to the Community Reinvestment Act. While public policy did play a minor role, it was greed that drove the problems.

Broker dealers figured out that they could blend the mortgage pools and retain a triple A rating on the bonds. The originators figured out they could get a slice of the yield spread on loans to uneducated/unsuspecting borrowers. Borrowers figured out they could buy first and second homes on speculation, never pay any principal, flip the house after a couple of years, pocket the profit without any tax liability. Works on all but the last one.

2) These repackaged loans are now known as CDO's, CMO's, SIV's.

To hide the riskiness of these loans, Wall Street took a percentage of the sub prime loans, and mixed them together with the good loans (prime loans) to develop income investments that were sold to investors and banks. These repackaged loans of had enough good loans (prime) to fool the credit rating agencies.

By not looking at what they were rating with a fine tooth comb, the credit rating agencies issued AAA ratings to investments that held a significant percentage of sub prime debt. As a result, many of the bond insurers issued insurance on mortgage back securities just because the rating agencies issued AAA ratings.

3) Many sub-prime loans were issued as ARM's-adjustable rate mortgages. As rates began to climb, the interest charged on ARM's reset each year at a higher rate. As interest rates rose, so did the mortgage payments for these sub-prime borrowers.

Lenders attempting to adhere to the rules of the Community Reinvestment Act issued ARM's instead of conventional mortgages because borrowers could obtain mortgage loans with little or no money down.

Since many 15 or 30 year fixed mortgages required a 20% down payment, ARM's became the favorite lending vehicles for banks attempting to comply with the Community Reinvestment Act.

In short,

-Congress was at fault for requiring banks to loan money to people with poor credit, bad credit, and low income.

-The Clinton Administration was at fault for watering down the requirements for obtaining a loan under the Community Reinvestment Act.

-Wall Street was at fault for developing, repackaging, and selling CDO's, CMO's, SIV's when they knew they were laced with junk.

- The rating agencies were at fault for not closely examining each and every invest they rate.

-Bond insurers were at fault for relying on the honesty of Wall Street, and the competency of the rating agencies.

4) The sub prime debacle has spilled over into the prime lending market. Real Estate speculators bit off more than they could chew, and prospective homebuyers took a big bite of a poison apple.

The feeding frenzy for real estate from 2003-2006 had all the earmarks of a major bubble. In 2003, the popular TV show "The Apprentice" took the nation by storm. The theme song leading into the show ("Money, Money, Money") inspired millions of Donald Trump wannabees to venture into the risky business of real estate speculation.

Other real estate shows appeared on Home & Garden TV such as "Flip that House" which further fueled the frenzy.

While many investors did well, the old Kenny Rogers song, " You got to know when to hold em, know when to fold em, Know when to walk away and know when to run", comes to mind.

I can't tell you how many people I warned as the bubble in real estate became apparent to everyone but the speculators. Unfortunately, many of the loans made to real estate investors were cut from the same cloth as the loans made to sub prime borrowers.

Real Estate speculators (flippers) borrowed money using interest only loans, and ARM's in hopes of paying as little as possible, and using the temporary leverage in hopes of selling their investments as quickly as possible at a substantial profit.

As real estate prices reached a climax, investors who had bought multiple properties were stuck without a buyer. As interest rates began to rise, the payments on ARM's and interest only loans began to rise.

In addition, Investors who bought into the preconstruction condo market began reneging on their 20% down payments, and letters of credit as condo prices began to fall leaving developers holding the bag.

As it stands now, real estate investors are holding out hope that the market will return to the glory days of 2003-2006, but I believe they may have to wait a lot longer than they had imagined. While I believe the real estate market will stabilize over the next few years, the glory days many not return for 10 years or more.

As a comparison, the last great bubble, the NASDAQ stock market, is still down -53% below its peak from March of 2000. That was 8 years ago!

The Federal Reserve & The Government is Working Overtime to Stabilize the Markets

The Federal Reserve has lowered its key lending rate to 2.25% from 5.25% a year ago. As a result, many banks have reduced their prime lending rates to 5.25% from 8.25% during the same timeframe.

As a result, consumers are paying 3 percentage points less on their credit-lines from a year ago.

Unfortunately, high energy costs, and falling home prices have eaten into consumers discretionary incomes. In the weeks and months ahead, energy prices should fall as the US economy enters into recession. One of the main culprits for high energy prices is a falling dollar. As the Fed aggressively lowers interest rates, the dollar has declined making oil more expensive.

Once the Fed is finished lowering interest rates, the dollar should rally and energy prices should fall. When the credit markets stabilize, the Fed will slowly begin raising interest rates (mid to late 2009- & 2010) which will reduce inflationary pressures. This will add even more stability to the dollar and bring oil prices back to an affordable range.

The Fed is working overtime to contain the sub prime fallout from affecting other areas of the prime market. I believe they will succeed. As a result, the crisis affecting the financial industry will end, and investors with a 2-5 year time horizon will be amply reward. In the interim, the stock market will remain volatile; interest on savings accounts, cd's and bonds will be incredibly low.

The stock market will begin to stabilize and move higher 6 months before an economic recovery. The best course of action is to slowly add to the equity markets as opportunities present themselves.

Real estate investors, like investors in the NASDAQ in 2000, will be slow to return to the stove that just burned them. As a result, the next big investment opportunity may very well be the major companies represented in the S&P 500, the Dow Jones Industrials, and the NASDAQ.

For the week:

-Gold closed at $927.00/oz +13.80 for the week. Last week gold closed at $913.20, and was trading at $936.50 two weeks ago.

I have said that Gold at $1000/oz looked much overbought. Once central bankers stop money pumping into the economy, I think a substantial correction in Gold will occur.

-The Commodities CRB Index closed at 407.45, up from 395.09 last week, and up from 394.54 two weeks ago.

-Crude Oil closed at $110.14 /bbl up from $106.23 last week, and up from $105.62 two weeks ago..

I still believe we will see $75-$85/ barrel oil in the weeks ahead. This is why I refuse to overweight oil in the ETF portfolio despite of the current rankings in our system. Oil has remained above $100 for the seventh consecutive week.

If Crude oil and commodity prices do not correct sharply, the US economy will remain in serious trouble.

-The U.S. Dollar closed at 71.78 down from 71.97 last week, but up from 71.61 two weeks ago.

The dollar has dropped to new all-time lows because of large account deficits, and rate cuts by the Fed. Once the rate cuts come to an end, I am looking for a decent rally in the dollar. The dollar may also get some help soon from the G-7.

Economic Reports This Week:

Monday-

1) March Retail Sales (previous -0.6%) and ex-autos (previous -0.2%).

Tuesday-

1) March Producer Price Index (previous 0.3%) and PPI ex-food & energy (previous 0.5%).

2) February Treasury International Capital Flows (previous: $47.2 billion).

3) April NAHB Housing Market Index (previous 20).

Wednesday-

1) March Consumer Price Index (previous 0.2%) and CPI ex-food and energy (previous 0.2%).

2) March Housing Starts (previous -0.6%), Federal Reserve's Beige Book.

Thursday-

1) April Philadelphia Fed Business Index (previous -17.4%).

Our current asset allocation is as follows;

70% Equities: (Normally 95%) Aggressive
60% Equities: (Normally 80%) Moderately Aggressive
50% Equities: (Normally 60%) Moderate
30% Equities: (Normally 40%) Moderately Conservative
10% Equities: (Normally 20%) Conservative