Over the past decade, Wall Street built a market for more than $2 trillion in securities sold globally and backed by loans to U.S. homeowners on two long-accepted beliefs and one newer one. The prevailing logic: The value of the American home would never fall nationwide, and people would almost always make their mortgage payments. The more recent twist: Packaging mortgage loans and turning them into securities would make the global economy more resilient if anything went wrong.
In a matter of months, though, much of the promise of the new financial architecture -- together with its underlying assumptions -- has proven to be a mirage. As house prices fall and homeowners default on mortgages at troubling rates, the pain has spread far and wide. An examination of the resulting crisis shows that it is comparable to some of the biggest financial disasters of the past half-century.So far, the potential losses look manageable compared with the savings-and-loan crisis of the 1980s and the tech-stock crash of 2000-02. But the housing debacle could yet take years to work out, thanks to the sheer complexity of it. Until the mess is cleaned up, investors will remain jittery and banks will likely hold back on all kinds of lending -- a credit crunch that is already damping global growth and could tip the U.S. economy into recession.
I realize that the WSJ almost by definition has to be conservative with this kind of language, but please... can we stop with this could/might/maybe recession nonsense? The questions aren't "if" or even "when." The questions are "how deep" and "how long." And to know that, all you need to do is read the first half of that sentence:
Until the mess is cleaned up, investors will remain jittery and banks will likely hold back on all kinds of lending
More:
The ultimate extent of the crisis will depend largely on how steeply the price of the average American home falls. That will play a pivotal role in determining how many people are at risk of foreclosure as payments on adjustable-rate mortgages tick upward and in the size of losses on securities backed by those loans. It will also affect the size of the hit that consumers sustain to their spending power.
House prices are down by 0.5% to 10% now, depending on the measure used. If they fell 30% -- what it would take to restore their historic relationship to inflation, rents and incomes -- $6 trillion worth of housing wealth would be wiped out. Measured against the size of the U.S. economy, that is less than what was lost in the stock market between 2000 and 2002. Initial guesses at total losses on subprime and similar mortgages range from $150 billion to $400 billion.The latter figure would equal about 3% of U.S. annual economic output. That is similar to the losses suffered by S&Ls and commercial banks between 1986 and 1995. But it is less than half the scale of Japanese bank losses in the wake of that country's burst stock and real-estate bubbles.
The current crisis, though, differs in crucial ways from the recent tech-stock bust and the S&L crisis.
For one, it centers on assets -- houses -- that, unlike stocks, most people have bought with borrowed money. On average, mortgage debt amounts to nearly half the value of houses. In recent years easy credit has allowed many to borrow up to the full value of their homes, making them more leveraged than any hedge fund.
As prices fall, people who find themselves owing more than their homes are worth are much more likely to renege on their mortgages, leaving lenders to sell the foreclosed houses at a loss. To make matters worse, payments on more than $500 billion in mortgages will reset in 2008, mostly to higher rates.
Banks are far less exposed to serious damage than during the 1980s. Nonetheless, the shift of loans from banks to markets has created a staggering complexity that threatens to prolong the crisis.
During the Latin American debt crisis, the Fed and U.S. Treasury were able to prod a few hundred banks to renegotiate billions of dollars in debt owed by a few dozen developing countries. "You had uncertainty in valuation, but it was more straightforward: You know how big the debt is, you know who has it, a relatively small group," says Mr. Volcker. "This is much more complex."
... Robert Shiller, a Yale University economist who has made a career out of studying bubbles, says the last bear market in stocks may have also made houses more appealing. A 2003 survey of home buyers he conducted with a colleague found 10 times as many said the stock market's collapse encouraged them to buy a home as said it discouraged them. Their thinking, Mr. Shiller says, went like this: "I'm fed up with the stock market, I had so many promises of high returns and my broker and the accountants were deceiving us. But homes have always gone up in value, and it gives me great satisfaction to own a home and I can see it everyday."
At first, home prices rose for good reason. With the economy in recession, the Fed slashed interest rates in 2001 and kept them low until mid-2004. That, plus an influx of foreign savings to the U.S., kept mortgage rates low. Former Fed Chairman Alan Greenspan frequently argued there could be no housing bubble. The high cost and inconvenience of moving "are significant impediments to speculative trading and...development of price bubbles," he said in late 2004.
But rising home prices may have given both buyers and lenders a false sense of the market's stability and security.
UPDATE: Here are just a few of the other headlines running on the WSJ home page right now:
Economists Get Gloomier: Economists said they see the risk of a recession rising and that the Fed should act to avert one, a WSJ.com survey found. Opinions were mixed on the Treasury-backed subprime plan. 9:00 p.m.
UBS's Subprime Hit Deepens Worries: UBS announced fourth-quarter write-downs of $10 billion, becoming one of the biggest casualties of the subprime meltdown. The bank also received a $11.5 billion capital infusion from Singapore's investment arm and a Middle Eastern investor. 10:56 p.m.
WaMu Retrenches After Hard Hit: WaMu will reduce its dividend and sell preferred stock in a move to raise $3.7 billion in capital. More job cuts are planned.
A $34 Billion Cash Fund to Close Up: Investors running for the exits have caused the closure of one of the largest U.S. short-term funds catering to institutional clients.
I coudl go on with 4 or 5 more, but I think you get the idea now, huh?
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