Submarined by the Subprime Frenzy

September 2, 2007
The Way We Live Now

Subprime Time

We are no longer shocked when the Dow Jones industrial average plunges 10 percent — as it did this summer — or when a single hedge fund, this one run by Goldman Sachs, drops 30 percent in a week. But real estate, we thought, was different. Hedge funds execute hundreds of trades a day, often according to the whims of a computer; people buy their homes one at a time and usually retain them for years. But last month’s market turmoil revealed a doleful transition for real estate. Formerly the most prosaic and dependable of investments, homes over the last 30 years had been turned into trading chips for Wall Street. And now, even at a time when the economy is still growing apace, two million Americans are suddenly said to be at risk of losing their homes to foreclosure. How did real estate become an industry with the vulnerabilities of esoteric financial instruments?

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The answer, like most seemingly inexplicable phenomena, is reasonably simple. Not reasonable certainly, but reasonably simple.

First, the ownership of a home came to be thought of as an investment that only increased in value. Second, ordinary people got used to ‘moving up’ from one home to another without additional cost. Third, lenders (who know a feeding frenzy when they see one) kept ‘moving down’ in both equity requirement and ‘initial’ interest rates to meet those increasingly shaky buyers, in order to keep the game going.

The game overheated. All those investors shoveling money into mortgages suddenly realized there was no equity in the market–just the hope of equity.

Finally, as surely as dawn follows night, ‘initial’ interest rates turned into the actual rates down there in fine print at the bottom of the page. And because no one really expected that to happen before they ‘personally’ had made other arrangements (like a good long-term rate or selling the house for a profit), it went ahead and happened.

Just as in 1929, when cab-drivers and shoe-salesmen have ‘can’t lose’ investments, they lose.

It’s the way markets work. And if home ownership wasn’t such a slice of American pie, the president and the Congress and the Federal Reserve would leave markets the hell alone and they would correct themselves.

Is that likely to happen 429 days before a national presidential election? Not even remotely possible.

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