Economic Armageddon?

The jury is still out but Jim Cramer, host of the always entertaining Mad Money on CNBC, thinks the fixed-income market is already in Armageddon. If you still haven't heard or seen Jim Cramer's freak-out on CNBC last friday, you should join the over 1 million people who already have.

For those living under a rock, the financial markets have been in turmoil in recent weeks over the crisis in sub-prime mortgages and fixed-income more generally. In July, Bear Sterns announced that two of the hedge funds were practically worthless.

The two funds had invested heavily in the sub-prime mortgage market, which imploded earlier this spring. The valuation puts a chill into the mortgage market, as other holders of mortgage-backed securities and derivatives may be forced to mark to market their securities with the same brush as Bear.

Earlier today, French bank BNP Paribas froze funds citing problems in the United States sub-prime mortgage market.

A recent spike in delinquencies among subprime borrowers — homeowners with weak credit histories — has led to broader turmoil in the credit markets. The pinch has hit private equity firms, which suddenly found themselves almost completely unable to sell debt to finance leveraged buyouts.

To provide some background, Joseph Stiglitz has a great article explaining how the how the housing bubble started:

American families were persuaded to take on more debt, refinancing their mortgages and spending some of the proceeds. And, as long as housing prices rose as a result of lower interest rates, Americans could ignore their growing indebtedness.

In fact, even this did not stimulate the economy enough. To get more people to borrow more money, credit standards were lowered, fueling growth in so-called subprime mortgages. Moreover, new products were invented, which lowered upfront payments, making it easier for individuals to take bigger mortgages.

Some mortgages even had negative amortization: Payments didn't cover the interest due, so every month the debt grew more. Fixed mortgages, with interest rates at 6 percent, were replaced with variable-rate mortgages, whose interest payments were tied to the lower short-term T-bill rates. What were called ''teaser rates'' allowed even lower payments for the first few years: They were teasers, because they played off the fact that many borrowers were not financially sophisticated and didn't understand what they were getting into.

So, what does this all mean? For starters, this looks like it might only be the tip of the iceberg. Besides the fact that some rich hedge fund investors will lose some money and that we will have some out-of-work bankers (oh, the travesty!), the real issue is the 7 million Americans who could lose their homes because they can no longer afford their mortgages.

But we shouldn't fear! Stephen Colbert has gotten in on the action and had Jim Cramer on his show last night. This is a great overview of the whole situation. Take a look,



~BT