“Why is it, that the subprime loan crisis has such a rippling effect on many sectors of the economy?”
“Why are even companies outside the USA also affected by the U.S. mortgage crisis?”
In the last 7 days I received lots of emails from my subscribers asking me questions like these, and I’d like to take the opportunity to explain what this housing, mortgage, subprime loan, credit crisis – whatever you want to call it – and the present situation is all about.
Between 2002 and 2004 the interest rates in the United States were as low as never before. At least as far as I can remember. I’m not that old yet! The effect of such low interest rates was a real-estate boom in the U.S. often financed with so-called subprime loans. These are loans given to borrowers who do not qualify for the best market interest rates because of their deficient credit history.
Subprime lending encompasses a variety of credit instruments, including subprime mortgages, subprime car loans, and subprime credit cards, among others. The term “subprime” refers to the credit status of the borrower (being less than ideal), not the interest rate on the loan itself.
But banks didn’t worry too much about this because interest rates were low and simultaneously, real-estate prices were rising continuously in the 90’s.
So back in 2002/2004, anyone that could count to 3 was given a loan. Many people in America were suddenly able to afford expensive single family homes and other kind of real-estate that they couldn’t before.
But in 2006 the U.S. interest rates had tripled and now, especially the subprime borrowers couldn’t pay their monthly installments anymore. So more and more of these subprime loans started to crumble.
But that’s not all. Some banks and other financial institutionals converted millions of these subprime loans into bonds. These were then sold for billions of dollars to banks, insurance companies and mutual funds that assumed this to be a secure investment because bonds usually are. That’s why they’re also considered a safe haven in stormy times.
And not only were these bonds sold to U.S. institutionals, but International ones too. You see, in a nutshell, everyone invests everywhere. America invests in Europe, and Europe invests in America, etc, etc.!
So you can imagine what happened when these loans started to crumble and the practice of converting them into bonds backfired. It all swept over the borders of America into other countries as well. The German industrial bank IKB invested 13 billion dollars in these bonds and now they are looking at a $5 billion loss.
For years this subprime game turned out all right and gigantic amounts of cash were invested into real-estate in Florida, Delaware or Texas by U.S. and international equity markets. No one thought that so many borrowers would go broke at the same time.
According to the U.S.Federal Reserve, loans of up to 100 billion dollars could bounce. At the same time, this seems to just be a drop in the ocean considering the effect it could have on international capital markets.
These bad loans could be the biggest single risk for the global economy. In the past, many in America spent their money stout-heartedly thus, stimulating and cranking up the economy. Their houses became worth more and more and banks literally threw loans at customers with low interest rates.
This could all backfire now putting a lot of pressure on the U.S. economy, because the money that was spent so generously is now being held back. Also because borrowers that are now up to their ears in financial troubles can’t spent anymore money because there simply is none left to spend. This, in turn, takes a lot of liquidity out of the markets.
Also companies and corporations that have nothing to do with the current real-estate turmoil are drawn into the subprime crisis. If they want new capital from banks, they have to pay higher interest rates as an additional premium for risk. Or, taking things into extremes, they won’t get a loan at all making it difficult for companies to grow, especially if a company wants to merge with another which often costs billion of dollars. This all drops out now thus, reducing earnings and profit outlooks.
And there’s another, equally bad effect on all companies. whether attached to any real-estate or not. Hedge funds bought these converted mortgage bonds by the millions and very often using margins i.e. buying on borrowed money. And now they are sitting on a huge heap of losses and debt. In order to pay back those debts they have to sell stocks, commodities and other equity. And this obviously pushes prices down. Also stock prices. It’s like a chain reaction.
And that’s basically the reason why the markets around the world are in such shambles right now.
Back at the trading floor, for Bullish trading the best hope for continued long trading is in turnarounds and bounce backs. Rather than hold your breath and open new long trades why not take the Bearish pat and trade puts or stand on the side lines for a time?
Is my trading bias still Bullish? In the short-term no. In the mid and long-term, yes. So I’m definitely not opening any new long trades right now. But in the future, we’ll be looking at plenty long trade opportunities. That’s the good side of it all!
Yours in Successful Trading,