Newsletter – January / February 2008 – Sub-Prime: The Understatement of the Year 2007

Sub-Prime: The Understatement of the Year 2007

What’s all the fuss about? Summer 2007: Why did the central banks of the most sophisticated economies in the world have to bail out the Big Banks? Autumn 2007: Why did the CEOs of America’s biggest bank and biggest brokerage firm resign? Why did Citibank and Morgan Stanley have to get financing from The Saudis and from China? Why did several Canadian banks announce monster “write-offs?” Why did the European central banks loan $500 billion to European big banks? What’s wrong?

It appears that million of Americans cannot afford their mortgage payments. As they hand their keys back to the lenders, houses have to be sold to pay off the defaulted mortgages. The selling pressure of all those extra houses on the market has caused a down trend in US house prices. If a home owner was having trouble making mortgage payments, and their mortgage was $300,000 –but the value of their house has dropped to $290,000, it makes them more likely to give up and walk away. In addition to that, potential home buyers are reluctant to buy when prices are going down. Increased supply of houses for sale, decreased demand: the down turn feeds on itself. It’s like a spiral – lower house prices cause even lower prices.

The reason that the world’s central banks have been so aggressively lending to the Big Banks stems from the way the banking system is structured. A bank has a certain amount of capital or the net worth. It also has a certain amount of deposits, the amount of money their customers have placed in accounts and investment certificates. The amount of money that a bank can lend to do its business is a multiple of their capital and their deposits. If their capital includes $1 billion of American sub-prime mortgages, and they realize that millions of Americans can no longer afford their mortgage payments, they realize that their $1 billion might not actually be worth anywhere near $1 billion.