Why the Sub-Prime Meltdown is a Problem

The big discussion on Wall Street today is whether or not the problems with sub-prime will impact alt-A and prime loans and if all of this will impact housing markets and the economy as a whole. I want to examine why and how sub-prime’s implosion will impact the housing market.

It is estimated that tightening lending standards are going to eliminate 21% of the buyers from the market.


We all know intuitively this sounds bad. But what is the impact?

For a deeper understanding read The Plankton Theory Meets Minsky.

This will result in lower prices. If prices are lower and standards are tightening, serial refinance will come to an end. Many, if not most of the borrowers needing to refinance over the next 5 years will be underwater when the loan resets resulting in more foreclosures.

March 2010 ARM Reset Schedule big

As you can see, it will take 5 years for the existing ARM’s to reset. For these people to be able to refinance, they must either have enough cash to buy down the loan (do you think any of them will?), or their house must be worth more than the loan amount. For the latter to happen, there must be a lot of buying in the market. Given that 21% of the buyers were just removed. What do you think is going to happen?