Beneath the Tip of the Iceberg

If you own a home, you have probably been well aware of the "sub-prime mortgage crisis" that has shaken the financial industry in recent months. For example, countless borrowers who opted for adjustable-rate mortgages are starting to see their mortgage payments rise—often to levels beyond their ability to pay, leading to financial ruin and often to foreclosure on the family residence.

If you are not a homeowner, or you do not have a variable-rate mortgage, you may think you are not affected by these troubles. But if that is what you think, you are wrong! The sub-prime mortgage crisis has complex consequences throughout the economy, and is actually the symptom of a far more serious problem that represents a far greater risk to the financial system of the United States—and the entire world!

Home mortgage woes are real, and they are serious, but they are only the proverbial "tip of the iceberg." It is what lurks beneath the visible iceberg that poses a far greater risk.

Unlimited Wealth?

It was not that long ago when millions of eager homebuyers across the United States believed the housing market was a source of unlimited wealth. The house you bought today would be a cash machine tomorrow, from which you could pull equity as its value rose, and rose.

Why did home prices keep rising? The U.S. Federal Reserve propped up the economy in the early years of this decade by increasing the money supply. Much of this increase was absorbed by the real estate market, making home ownership more desirable. As a result, the growing demand for homes caused prices to rise. Lenders began to take for granted the assumption that housing prices would continue to rise, and that as a result they could make loans to people with very little equity (money of their own invested in the home), or with poor credit histories. The assumption was that even if a mortgage-holder defaulted, the lender's investment would be protected by the increasing value of the real estate.

A mortgage is considered "sub-prime" if it is made to a borrower with a weak credit history, or if it is not well-secured by the underlying value of the real estate. There are only so many borrowers with secure, high-paying jobs and a 20 percent down-payment on a home, who are seeking a loan worth no more than two or three times their annual household income. Those "prime" loans formed a smaller and smaller proportion of the market when the "housing boom" took off, and lenders felt they could get away with making loans to people who might pay just 3 percent (or less) of a home's value as a down-payment, and who might be taking out a loan worth five or six times their annual household income.

With so much money to be made, mortgage brokers began approving loans to people who clearly could not afford them, trusting that the increase in real estate value would be enough to ensure profitability. Even if a homeowner could not pay the mortgage when an adjustable rate loan payment doubled or tripled, the lender could still recover its loan from the increased value of the home.

Of course, with so much riding on the assumption that housing prices will increase, a downturn in the economy—and thus in the housing market—spells trouble. If a loan was made for 90 percent or even 97 percent of a home's value, even a relatively small drop in property values can leave the borrower "upside down" on the loan—owing more than the house is worth. And once a home is worth less than its home loan, there is far less incentive for the borrower to keep paying. Add to that the pinch of an increased mortgage payment when an adjustable-rate mortgage changes to reflect current interest rates, and this is a recipe for disaster.

Borrowers with weak credit histories—the very ones to whom so many sub-prime loans were made—are typically the first to default on home loans. Consider a borrower who took out a $300,000 mortgage on a home, contributing just $10,000 as a down payment and paying $1,500 per month on an adjustable rate mortgage. If the home's value drops just 4 percent, and the monthly payment jumps to $2,500 per month, many borrowers may be reluctant to pay. Add to that the sad fact that in a weakened economy, homeowners who lose their jobs may be unable to pay, and you can see how the numbers of home foreclosures can skyrocket.

When homeowners default on a mortgage, they are not the only ones who suffer. The investors whose money funded the mortgage can lose their investment if the defaulted amount is greater than the value of the home against which the mortgage was taken.

"Who cares about the wealthy investors?" some may say. "The real problem is the homeowner." Well, in our modern economy, many homeowners are also pension-holders or investors, whose retirement income may depend on mutual funds heavily invested in home mortgages.

Typically, after a mortgage broker generates a home loan, it is quickly sold to another investor and it becomes pooled with other mortgages into financial instruments valued at tens of millions of dollars or more. These pooled mortgages are then used to secure bond issues or other financial instruments which are then sold to investors as mortgage-backed securities. A homeowner only knows the name of the servicer to which he sends the monthly mortgage payment, but that payment may ultimately be received by a wide range of investors who have acquired a stake in that mortgage. A home mortgage can find itself the subject of complex financial instruments designed for sophisticated investors; there are even some cases where investors contract to receive only the cash flow that results from late fees on mortgages, hoping to profit from a downturn in the economy.

The situation becomes more complex when some investors use borrowed funds to invest in other people's mortgage borrowing. This creates the potential for a cascading disaster. When the credit-worthiness of pooled mortgages declines as a result of sub-prime loans going into default, lenders may demand repayment of their loans. With no ready market for the now-devalued pooled loans, what can the investor repay with?

When much of an asset's value was based on the perception that it was a sound investment, its value can drop speedily in a time of financial crisis. Much as a homeowner may be left "upside down" on a home mortgage, institutional investors may be left holding financial instruments worth less than they can possibly sell those instruments for. Assets that cannot readily be sold are said to be "illiquid." As investments' value drops, the resulting liquidity crisis can cause even major financial institutions to fail, and could provoke a chain of "cascading failures" in which one failure brings another institution down.

In such an environment, it is no surprise that Wall Street in the past year has seen some big losses and real scares. Recall what happened earlier this year to the well-established Wall Street firm Bear Stearns, which sought and received emergency funding backed by the U.S. government, so that its former rival firm J.P. Morgan Chase & Co would be willing to step in and purchase the firm, averting a major financial crisis. How successful was this intervention? As the Wall Street Journal reported, "While the move signaled that the Fed was trying to move aggressively to prevent Bear's crisis from spreading to the broader economy, it seemed to do little to soothe fears" ("Fed Races to Rescue Bear Stearns," March 15, 2008).

Even Europe has felt the sting of these U.S. problems. The largest bank in Switzerland, UBS, has announced it is taking $38.29 billion in losses on its subprime-related assets. Other major financial institutions taking large losses include Merrill Lynch ($25.09 billion), Citigroup ($21.65 billion), AIG ($17.20 billion), Morgan Stanley ($13.12 billion), Deutsche Bank ($7.35 billion) and Royal Bank of Scotland ($6.00 billion). Clearly, the subprime mortgage meltdown has delivered a major shock to the world's banking system.

The Rest of the Iceberg

Much media attention has been focused on subprime mortgage loans. Few seem to realize that a similar phenomenon has been underway in a much larger arena—the huge business loan portfolios held by commercial banks, both large and small. These banks' core business is making loans to other businesses—for equipment, inventories, receivables, lines of credit and many other needs. Loans in this sector can range from tens of thousands of dollars, up to hundreds of millions or even billions of dollars.

The same easy money that led to so many subprime mortgage loans also caused bank deposits to increase. As banks had more money on hand, they felt increased pressure to make more loans to businesses. Just as in the home mortgage industry, commercial bankers felt they had to make ever-more-risky loans in order to remain competitive. As loan volumes increased, banks' loan portfolios were put at greater risk. When a borrower defaults on a commercial loan, the bank pays for that loss out of its own capital base—which often amounts to about 5 percent of its total assets. Although banks are required to carry reserves to accommodate losses, a rapid rise in loan defaults can quickly overwhelm a bank's reserves and capital.

The volume of U.S. banks' business loans dwarfs the volume of subprime home loans—putting that vital sector of the economy at grave risk of a meltdown far more severe than has already been seen in the subprime mortgage industry. The U.S. Federal Reserve has been flooding the economy with liquidity in an attempt to offset the problem, but many observers doubt whether this is the right medicine for the ailing business economy. As the U.S. economy declines, an unknown volume of "subprime" business loans will default, and will need to be either restructured or repaid. But repaid with what?

This huge risk exposure in commercial bank loan portfolios is causing panic among many bankers, regulators and financial analysts. No one knows the full extent of the risk, yet if enough commercial loans begin to default during a recession, this could bring about a much-feared cascading of failures among interdependent financial institutions. Analysts are already predicting how many banks will fail in various regions of the U.S.—and the number of projected failures is growing. Banks can be hurt financially even if loans do not go into default; when existing loans are assessed as more risky than before, a bank may be forced to curtail its lending severely.

Analysts are attempting to gauge the risk banks are facing—to determine the size of the iceberg that is lurking in the banking industry, below the visible surface of the U.S. economy. Moody's Investors Service projects that in 2008, the corporate default rate will grow fivefold or more from 2007's already-record lows—up to 5.3 percent, from less than 1 percent in 2007. Moody's estimates that roughly $48 billion in highly risky "speculative-grade" corporate bank loans will mature by 2010, the majority occurring next year and the year after.

The total volume of all bank business loans maturing in the next couple of years is much greater than the $48 billion Moody's cites in speculative-grade loans. A recession can convert even high-quality business loans to speculative-grade.

Signs from the Stock Market

By looking at the stock market, we can gain some insight into how investors view the nation's banks. Investors, by determining what they are willing to pay for a stock, are in effect predicting and taking into consideration changes in profits, losses and asset values of publicly traded corporations. When a bank's stock price declines, this can reflect investors' opinion of the bank's underlying security, determined in significant part by the risk of its loans.

What is the stock market telling us about several major national and regional banks? Stock in Wachovia Bank, one of the nation's largest and most successful banks, was trading at 59.85 per share in April 2006. By March 2008, it had dropped to less than half that value, trading below $26 per share. Wachovia's earnings per share have dropped from $4.61 per share in 2006, to nearly zero (3 cents per share) in the fourth quarter of 2007.

Many regional banks are not faring much better. BankAtlantic is a regional bank doing business in Florida. In July 2005 its stock was trading for $18.85 per share; by June 2008 it had plummeted to less than $1.80 per share. Clearly, the credit crisis is putting institutions at risk throughout the U.S. banking system.

Recent moves by the Federal Reserve Bank show panic at the highest levels. The Federal Discount Rate exerts a major influence on the U.S. money supply, and short-term interest rates tend to rise or fall along with it. The Federal Reserve has slashed the rate from 6.25 percent a year ago, down to 2.25 percent as of June 2008. The governors of the Federal Reserve are using easy access to money as medicine for the ailing banking industry, because this is one of the very few tools it can use to try to help. But there is a saying, "When all you have is a hammer, every problem looks like a nail." Some analysts wisely observe that it was the Fed's "easy money" policies of 2002–03 that planted the seeds of the subprime mortgage mess in the first place!

As sobering as it may be, the subprime mortgage mess may be only the first in a series of major shocks to affect the U.S. and European banking systems. A recession of any significant length and severity could easily cause commercial real estate loans to go sour, followed by an unknown volume of business loans. The risk of systemic failure—of defaults in one sector of the economy leading to a "cascade" of defaults throughout other sectors—is giving many experts cause for grave concern.

A Unique Perspective

We can study the economy to understand the immediate causes and consequences of economic troubles in our nations. But there is a source we can consult to understand the "big picture" and put it in a context unknown to most financial analysts. Bible prophecy provides a unique perspective on world events, revealing the "future history" of the U.S. economy—as well as that of Europe.

If we understand why the U.S. became so wealthy, we should be able to understand how it can remain wealthy—and what can cause it to lose its wealth.

Certainly the U.S. has plentiful natural resources, but so do many other nations. When settlers arrived in Virginia and Massachusetts in the early 17th century, they found little more than wilderness. But when immigrants arrived at New York's Ellis Island in the waning years of the 19th century, they saw the Statue of Liberty in the harbor, tall buildings across the city, roads, houses, apartments, offices and factories providing jobs. Where did all that wealth come from? Most economists today would answer that it came from millions of hours of labor, as Americans worked productively to add utility and value to their economy.

Indeed, the U.S. economic system has produced a standard of living and a vibrant economy that has long been the envy of the world. But the God of Abraham, Isaac and Jacob gives us the true explanation for national wealth—an explanation that has long since been forgotten by most: "Beware that you do not forget the Lord your God by not keeping His commandments, His judgments, and His statutes which I command you today, lest—when you have eaten and are full, and have built beautiful houses and dwell in them; and when your herds and your flocks multiply, and your silver and your gold are multiplied, and all that you have is multiplied; when your heart is lifted up, and you forget the Lord your God who brought you out of the land of Egypt, from the house of bondage; who led you through that great and terrible wilderness, in which were fiery serpents and scorpions and thirsty land where there was no water; who brought water for you out of the flinty rock; who fed you in the wilderness with manna, which your fathers did not know, that He might humble you and that He might test you, to do you good in the end—then you say in your heart, 'My power and the might of my hand have gained me this wealth.' And you shall remember the Lord your God, for it is He who gives you power to get wealth, that He may establish His covenant which He swore to your fathers, as it is this day. Then it shall be, if you by any means forget the Lord your God, and follow other gods, and serve them and worship them, I testify against you this day that you shall surely perish. As the nations which the Lord destroys before you, so you shall perish, because you would not be obedient to the voice of the Lord your God" (Deuteronomy 8:11–20).

Yes, God's blessing is essential for the success of the productive process of any nation. He gives a nation the power to get wealth. Yet many in the U.S. have broadly rejected the traditional values that once provided the nation's strength. God warned long ago that "the Lord will greatly bless you in the land which the Lord your God is giving you to possess as an inheritance—only if you carefully obey the voice of the Lord your God, to observe with care all these commandments which I command you today. For the Lord your God will bless you just as He promised you; you shall lend to many nations, but you shall not borrow; you shall reign over many nations, but they shall not reign over you" (Deuteronomy 15:4–6).

The U.S. once had the wealth to be a lender to other nations, but is now the world's biggest debtor. Yet God also says He can reverse a nation's fortunes, blessing or cursing in accord with the nation's obedience or disobedience. "Behold, I set before you today a blessing and a curse: the blessing, if you obey the commandments of the Lord your God which I command you today; and the curse, if you do not obey the commandments of the Lord your God" (Deuteronomy 11:26–28).

Thankfully, each of us can change course individually, and can repent before God of our own sins. Have you done so? The American ship of state is speeding along, disregarding God, and the tip of an iceberg has been sighted. Below the surface looms the rest of the iceberg. Will America change course before it is too late?