The Crackprime epidemic

The Crack Cocaine Epidemic vs The Sub Prime Mortgage Meltdown

The Crack Cocaine Epidemic vs The Sub Prime Mortgage Meltdown

Sending off the final season of The Wire (hallowed be its name) recently there seemed to something familiar about the drug related scenes of inner city depravation and the injustice of the already rich draining dirt poor communities of their meagre resources and then fecklessly spending gains on big cars; then it struck – its contemporary banking and finance, best represented by the mortgage backed securities and its very own crack cocaine – Sub Prime.

Crack Cocaine

Sub Prime Mortgages

Origins

During the early 80s cocaine was trafficked through the Bahamas. During 1983-1984 there was a large surplus of supply causing the street price of powdered cocaine to drop 80%, lessening the profits of the cartels and dealers. Crack repositioned cocaine from a luxury product losing its value to a cheap, ready to use product causing an instant, but short lived high.

OriginsTraditionally banks had funded their mortgage lending with the deposits they received from customers, this limited the amount of lending they could do, meaning they would only lend to ‘prime’ customers. Banks started selling mortgages bonds, raising vast amounts of capital which allowed them to sell mortgages to virtually limitless amount of customers.

Opening up new markets

Prior to the introduction of crack, cocaine cost around $100 per gram making it the preserve of the predominantly white, metropolitan middle classes. The introduction of the $2.50 crack rock opened up vast new, predominantly black markets in the inner cities.

Opening up new markets

Prior to the introduction of sub-prime, mortgages were out of the reach of large segments of the predominantly black and Hispanic inner city population, who couldn’t afford a deposit on a property, didn’t earn enough to make repayments and had low credit scores. Sub prime allowed these people, previously regarded as too high risk by banks, to enter the housing market.

Marketing & growth

Crack hit the inner cities hard, making a major impact on New York, Los Angeles, Chicago, Washington and Miami by 1985. The drug then spread out of its inner city seeding ground and was available in 28 states by 1986. Initially street hustlers focused their efforts in deprived, mostly black areas giving away free samples to hook their customers, before hiking prices.

Marketing & growthSub prime lending was rare until the mid 1990s, soaring yearly until it comprised 20% of all new mortgages by 2006, burgeoning out of working class black areas, before spreading rapidly across the whole of America. Initially mortgage brokers would giveaway Adjustable Rate Mortgages which hooked consumers on a low month repayment for two years before being ‘reset’ at a cost sometimes100% higher for the rest of the term.

Size of market

1997 report by United Nations Office on Drugs and Crime estimated the value of the global drug market at $400bn, behind only oil and arms in annual turnover. Extrapolating the US market for crack from this figure is difficult due to the subversive nature of the business but $80bn is not far wrong.

Size of market
Now the mortgage bond market is worth $6 trillion, and if we assume an average income of 5% on this stock, that give us $300bn of annual value.

Legislative Discrimination

Previous to a new ruling last December crack dealers (85% of the federal inmates behind bars for crack offenses are black) were receiving longer sentences than powdered cocaine dealers (predominantly white) for equivalent offences. The ruling readdressing the balance will see 20,000 drug dealers released early.

Administrative Discrimination

Black and other minorities disproportionately fall into the category of "subprime borrowers" often because of lower credit scores, but in many cases are labelled sub prime even when income levels and credit scores were comparable with whites.

Who got rich? –Medium sizeMedium level, San Diego based crack dealer turned celebrity chef Jeff Henderson was pulling in $35,000 per week prior to his arrest.

He was sentenced to nearly 20 years in federal prison.

Who got rich? Medium size

Often described as the street hustlers of capitalism countless mortgage brokers made fortunes selling sub-prime; through fees and a kick back from the lenders known as a ‘yield-spread premium’ a kick-back from the lender which is a reward for placing the borrower into a higher-interest loan than what he would normally qualify for.

Who got rich? – Super size‘Freeway’ Ricky Ross was selling $2 to $3 million of crack in one day through a coast to cost operation encompassing LA, St Louis, New Orleans, Texas, Kansas City, Oklahoma, Indiana and Seattle. His HQ was serviced by a maid, featured a NBA regulation basketball court, contained a 1 ton safe, currency counting machines, and an underground tunnel accessible through a cupboard. He stated in interviews that he personally counted 2.8 million in cash one day.

He was arrested and sentenced to life in 1996, the sentence was subsequently reduced to 20 years on appeal.

Who got rich? Super sizeTraders across the globe made vast sums from sub prime, managing to make out even when the meltdown started. Hedge fund billionaire John Paulson personally made $3,7bn by betting against subprime in 2007. US hedge fund magazine Alpha, published a report earlier this year in which it stated five head fund managers including Paulson and George Soros all individually earned more than the $1.2bn by shorting subprime.

No one has been arrested as no-one has done anything illegal.

The effectsAn immediate consequence was that by 1984 cocaine related emergencies in hospital had risen by 12% and by 110% by 1986. Dealers targeted low-income inner city consumers who would invariably fall on hard times due to the cost of maintaining their habit, this led to a huge surge in robbery, theft and homelessness. Between 1984 and 1994 the homicide rate for black males aged between 14-17 more than doubled.

The effectsThe Meltdown began in 2006, when sub-prime mortgages deals signed 2 years ago began resetting at double the interest rate. The BBC identifies Cleveland as the Subprime capital of the USA; blighted by foreclosures and repossessions, by late 2007 one in ten homes in Cleveland was owned by Deutsche Bank Trust. Cleveland is now facing a rising crime wave, and the cost of demolishing the vacant houses alone will cost the city $100m of its tax base. According to Jim Rokakis, the County Treasurer for Cleveland's Cuyahoga County, "Wall Street strategies that made the cycle of no-money-down, no-questions-asked lending possible have sucked the life out of my city".

2 million more Adjustable Rate Mortgages are due to ‘reset’ in 2009.