The meltdown in the subprime mortgage market is inexorably spreading throughout the U.S. economy. The first shoe dropped in February, when scores of mortgage originators went bust amid rising defaults and tightening lending standards. Last week, the second shoe dropped as two CDO-focused Bear Stearns hedge funds blew up. Overshadowed by the Bear Stearns drama which unfolded at the same time, California-based brokerage firm Brookstreet Securities shut its doors when unsecured customer losses from margined investments in collateralized mortgage obligations were unexpectedly marked down. However, as the subprime monster likely resembles a giant centipede, this will not be the last shoe to drop.

Bear Stearns’ reluctance to mark down the value of their overpriced CDOs is mirrored by an equal desire among homeowners to hold tight to their fantasies of real estate riches. Despite the obvious weakness in the current market, deluded sellers continue to behave as if the boom of 1998-2005 never ended. A recent survey by Boston Consulting Group showed that 55% of home owners believe they could sell their house for more now than a year ago, and nearly three-quarters think they could sell their homes within the next six months at a price they set. Is it any wonder that there is a record 8.9 months supply of new homes on the market?

Just as CDOs are not worth the “marked to market” value conveniently assigned by Wall Street, homes throughout the country are not worth anything near the asking prices listed on “For Sale” signs. Wall Street may be able to buy some time by bailing out troubled hedge funds to keep their worthless subprime mortgage investments off the market, but no such safety nets exist for strapped consumers looking down the barrel of resetting adjustable rate mortgages. Inventories will continue to balloon until reluctant home owners come to their senses and slash prices.

If they do not do it themselves, appraisers, just like Brookstreet Securities’ clearing firm will do it for them. Imagine the effect on the economy when America consumer’s biggest assets turn into their greatest liabilities!

However, as I have been writing for years, the biggest losers in the real estate bubble will not be the borrowers who took advantage of easy credit, but the lenders who foolishly underwrote the loans. Whether they be unsophisticated clients of small brokerage firms like Brookstreet, or big time hedge fund clients of Bear Stearns, anyone who owns subprime mortgages is going to lose money. Some will lose 100% of what they invested, and those who used margin may lose even more.

The main problem was that Wall Street, hungry to feed the profit-rich CDO market, convinced the mortgage industry to abandon all traditional lending standards. In prior years, when borrowers were required to make sizeable down-payments, lenders were assured that borrowers would not knowingly commit themselves to mortgages that they could not afford, and that sufficient collateral would exist were defaults to occur. In addition, by verifying incomes and assets, lenders gained further assurance that loans would actually be repaid.

Once lenders dropped down payment requirements, the stage was set for the unfolding disaster. The advent of no-documentation loans, especially ARMs with teasers rates, interest-only payments and negative amortizations, further allowed risk free speculation to run rampant. Is it any wonder house prices rose so high when Wall Street allowed so many people to gamble with other people’s money?

If borrowers actually had to put their own hard-earned money down, they would have thought twice before committing themselves to mortgages they could not afford. But once Wall Street took all of the risk out of real estate speculation, there was no reason not to roll the dice. So borrowers lied about their incomes and stretched to meet payments because if home prices kept rising all the profits would belong to them. For years it was a stunningly successful bet that minted real estate tycoons by the hundreds of thousands. And, if prices reversed course, they had nothing to lose, as they put nothing down. Buyers could walk away from their bad bets none the worse for wear, leaving lenders to cover their losses.

However, amidst the hysteria and oblivious to their own roles in perpetuating the bubble, lenders also believed that real estate prices could only go up. With such assumptions, defaults seemed unlikely and ultimately riskless (a foreclosed property worth more than the underlying mortgage is a boon). Also, in many cases, as hedge fund managers made huge profits by risking their client’s money, both the borrowers and the lenders had no skin in the game. All the risks were transferred to those who purchased the re-packaged loans, and who are now left holding the bag.

All of the pundits and so called “experts” who did not see this coming still do not appreciate the magnitude of the mortgage disaster and how it will impact the housing market in general, the economy, the stock market, the dollar, interest rates, inflation, and the price of gold. They are content to believe government hype about the resilience of the American economy. On Tuesday, just as home building giant Lennar reported huge losses due to a weak pricing environment, the government told us that new home prices basically held firm to last years gains. Later in the week, similar losses blamed on falling home prices were reported by KB Homes. Just like with the CPI, this is yet another example of government numbers being in sharp contrast with reality and why they should always be taken with a grain of salt.

The curtain has yet to close, but if you listen closely you can hear the fat lady warming up in the wings. It has been one hell of a show, but there will be no encore. For those holding toxic mortgage paper there is nothing left to do but sue. However, even those who do not own this stuff are not in the clear. A much larger disaster looms for holders of U.S. dollar denominated assets in general. It will not be long before our foreign creditors realize that Uncle Sam is the biggest subprime borrower of them all and will similarly mark down the value of its debts as well.

by Peter Schiff
http://www.europac.net