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Who gets Burned in the Subprime Meltdown? Everybody   (March 7, 2007)

Much of the current "relief rally" in the stock market is based on the heavily hyped view that the subprime mortgage meltdown currently underway will be safely quarantined to those unlucky souls who are losing their homes and the lenders who own the "distressed mortgages". Nothing could be further from the truth.

We start our drill with who owns what in the U.S. I am indebted to the excellent website Wealth, Income, and Power by G. William Domhoff for this data, although it is also available from other sources as well (such as the U.S. Census).

The reason we start here is straightforward: those who own no assets to speak of cannot lose much when derivatives, mortgage-backed securities, shares in mortgage lenders and the banks which are linked to them, etc.--all the cornered victims of the subprime meltdown--decline.

As we can see in this chart, the vast majority of financial wealth and net worth is held by the top 10%:

So exactly how much do the people who took on subprime mortgages stand to lose? Very little, because they have few assets which are vulnerable to foreclosure or bankruptcy. As the following chart reveals, most of the assets of the 90% "underclass" (yes, I am a proud member) are concentrated in pensions and life insurance (which cannot be pillaged by bankruptcy proceedings) and principal residence--which in the case of subprime borrowers in the past few years, is unlikely to be much given the recent decline in house values. The 90% underclass has one concentration worth noting: that of debt.

In plain English: the top 10% own the assets, the bottom 90% "own" the debt.

Wealth distribution by type of asset, 2001
 Investment Assets
Top 1 percentNext 9 percentBottom 90 percent
Business equity57.3%32.3%10.4%
Financial securities58.0%30.6%11.3%
Stocks and mutual funds44.1%40.4%15.5%
Non-home real estate34.9%43.6%21.5%
 Housing, Liquid Assets, Pension Assets, and Debt
Top 1 percentNext 9 percentBottom 90 percent
Pension accounts13.3%47.0%39.6%
Life insurance12.5%33.5%54.0%
Principal residence8.9%28.0%63.0%
Next up: the distribution of income. The key point here is that the wealthy rather naturally draw a huge chunk of their income from assets: dividends, capital gains, interest payments, hedge fund gains and so on. If the subprime meltdown hits lenders and stocks, then both assets and the sources of asset-based income will decline.

Distribution of income in the United States, 1982-2000
Top 1 percentNext 19 percentBottom 80 percent
In other words: since the wealthy rely so heavily on capital gains and other asset-based income, the destruction of those assets and gains will impact them far more than Joe and Suzie Sixpack who earn virtually their entire income from working at a job. Here is an excerpt from the above report which describes the relation between assets owned and income:

The most recent findings on income inequality come from the New York Times' analysis of a November, 2006, Internal Revenue Service report on income in 2004. Although overall income has grown by 27% since 1979, 33% of the gains went to the top 1%. Meanwhile, the bottom 60% were making less: about 95 cents for each dollar they made in 1979. The next 20% - those between the 60th and 80th rungs of the income ladder -- made $1.02 for each dollar they earned in 1979. Furthermore, the Times author concludes that only the top 5% made significant gains ($1.53 for each 1979 dollar). Most amazing of all, the top 0.1% -- that's one-tenth of one percent -- had more combined pre-tax income than the poorest 120 million people (Johnston, 2006).

A key factor behind the high concentration of income, and the likely reason that the concentration has been increasing, can be seen by examining the distribution of what is called "capital income": income from capital gains, dividends, interest, and rents. In 2003, just 1% of all households -- those with after-tax incomes averaging $701,500 -- received 57.5% of all capital income, up from 40% in the early 1990s. On the other hand, the bottom 80% received only 12.6% of capital income, down by nearly half since 1983, when the bottom 80% received 23.5%.
Frequent contributor U. Doran forwarded this brilliant exposition of just how dependent the wealthy are on the "plankton"--the 5% of recent home buyers who couldn't really afford to buy a home but did so with "liar loans," subprime mortgages, Alt-A mortgages, ARMs and other risky debt:

The Plankton Theory Meets Minsky (PIMCO Bonds website):

The ongoing meltdown in the sub-prime mortgage market would not matter, except for those directly involved, except that it marks the unraveling of Ponzi finance units that, on the margin, were the plankton of the bubbling property sea of recent years. As the bubble was forming, riding on first-time homebuyers with first-time access to credit on un-creditworthy terms, and first-time speculators riding the same with visions of bigger first-time fools to take them out, all looked well. But as Minsky warned, stability is ultimately destabilizing, as those who require perpetual asset price appreciation to make book are forced to sell to make book. Such is reality presently in the U.S. residential property market, which has flipped from a sellers’ market on the wings of buyers with exotic mortgages to a buyers’ market of only the creditworthy.

Which means that the bigger fish in the domestic and global economic sea are going to be living on leaner diets. It also means that any given level of central-bank enforced short-term policy rates will become ever more restrictive with the passage of time. That is nowhere more the case than in the United States, where mortgage originators’ orgy of Ponzi finance stifled the Fed’s ability to temper irrational exuberance in housing with hikes in the Fed funds rate.
Contributor Doran also recommended this article which indicates just how widely the damage being inflicted by U.S. subprime meltdown is distributed around the globe: Barclays carrying $1bn of exposure to sub-prime lender:
Barclays faces being caught up in the US sub-prime lending rout as it emerged that it has a $1 billion (£520 million) line of credit to one of the biggest and most tarnished players in the industry.

Barclays has the exposure to New Century Financial Corporation, which late on Friday said that it was in danger of breaching loan covenants. Its shares crashed by 63 per cent to $5.48 yesterday — a tenth of their value two years ago.
So who loses in the subprime meltdown? The 5% of the population who couldn't afford a standard 20% down, 30-year fixed mortgage, of course, and everyone who's chief asset is a house; and finally, the wealthy, for it is they who are invested (via hedge funds and their own accounts) in the derivatives, CDOs (collateralized debt obligations), shares in financial companies, REITs, etc. which are going to take the ultimate hit as toxic subprime mortgages trip a domino-like series of losses.

If you look at the chart above, you'll note that much of the bottom 90%'s assets are in their residence. What this means is: as housing declines in value, the chief asset of the middle-class--the home--is directly reduced. Not quite as visible but just as important is the damage which will be inflicted on pension funds and life insurance companies as the losses ripple into their holdings. It is an open secret that these supposedly conservative fund managers have loaded up on risky assets in recent years, seeking higher returns.

So what happens to the other great middle class assets--life insurance and pensions--when pension funds and life insurance companies start admitting huge trading losses? Outright bankruptcy of such funds and companies is not at all unlikely.

For more on the risks posed to homeowners, lenders and holders of mortgage-backed securities and derivatives. please read my previous entries on these subjects:

Foreclosures and Financial Ruin: How Bad Will It Get? (April 26, 2006)

How Many Foreclosures Will Hit the Market? (May 1, 2006)

Housing Bubble Bust Will Take Down the Global Economy (May 8, 2006)

Housing: 10% Decline May Trigger Financial Ruin (May 22, 2006)

Mortgage Lenders on the Precipice (September 1, 2006)

Derivatives and the Real Estate Bubble (November 8, 2006)

For more on this subject and a wide array of other topics, please visit my weblog.


copyright © 2007 Charles Hugh Smith. All rights reserved in all media.

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