Well in one week we lost Freddie Mac, Fannie Mae, Lehman Brothers, and Merrill Lynch, some of the biggest financial firms in the country and the world. And now there are talks that Morgan Stanley will merge or be bought out as well, and then there was one, Goldman Sachs. Out of the five biggest investment firms in the nation only one may be left standing. So what happened? Well its complicated but simple. These firms used leverage to maximize profits while the housing boom was in full steam. Let me explain. Some of these firms borrowed up to $30 dollars for every dollar in assets and while this is a very risky strategy, it can pay big dividends if executed properly. It’s called trading on the equity or using leverage.
See companies get a tax break on interest expense paid to its creditors. For instance you have net income before taxes but after expenses of say $2 million dollars and an interest expense of $150,000. That $150,000 is deducted from the $2 million and then you are taxed on the difference. This will increase the bottom line by using the interest expense as a deduction. Companies have quite a few ways to raise capital to finance its operations but the two main ways is to issue stock or issue debt. Issuing stock dilutes shareholder ownership but is a cheaper way to raise capital. But by issuing more shares net income now has to be spread over more shares outstanding lowering its EPS or earnings per share. By issuing debt and not issuing stock the company can reflect a higher EPS, more income spread over fewer shares of common stock outstanding.
This is all fine and dandy when revenues are growing but in sharp economic downturns this can cause the insolvency of a company very quickly. Take Countrywide for example, this company operated on leverage and when investor confidence eroded, they started to dump shares of Countrywide reducing its market cap by billions of dollars in a matter of a few short weeks. When creditors wouldn’t renew their notes, and after they tapped their lines of credit, the company was then bought out by Bank of America for $4 billion in stock.
This may seem very frightening and the media has made the word mortgage an ugly word claiming that the subprime mess caused it all. Well that’s only a small piece of the puzzle. In 2006, which was the peak of the subprime boom, 20% of all originations were considered subprime, roughly $800 billion dollars. While this is surely a lot of money it pales in comparison to the roughly $3 trillion dollars in mortgage originated in that year. Alt-A is becoming a recent problem, which represented 13% of originations in 2006, and was responsible for the majority of Fannie and Freddie losses in the past quarters. However in the midst of all this bad publicity there are still a great percentage of subprime borrowers making their payments. The real cause of this financial problem was the greed on the Wall Street, bad news causing naked short selling driving down the stock prices of financial stocks, and the lack of transparency in risky securities like CDO’s (collateralized debt obligations).
The value of these assets were grossly overestimated and was shown clearly by the liquidation by Merrill Lynch for 22 cents on the dollar which pushed them to a huge loss in their last quarter.
Regardless of what is going on right now it is still a great time to buy a home. Right now interest rates are still at historical lows and prices have retracted in some areas in the double digits. The cost of waiting right now in this volatile market is too great to let it pass you buy. Its funny how they talk about how hard it is to obtain a mortgage but the media never wants to talk about FHA insured mortgages. Its being estimated now that FHA originations, after only being a mere 2% in 2006, will skyrocket to 30-35% for 2008 and even more in 2009. FHA insured mortgages are a great way to get into a home with little down payment and competitive interest rates. Conventional loans right now are being hit heavy with credit score and ltv adjustments to pricing that drives the interest rate up for borrowers who have less than 740 credit scores. Don’t wait now is the time to take advantage of this market cycle.
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