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It pains me to say this, but this time Alan Greenspan is right about housing.
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Paul Krugman.
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Mr. Greenspan was wrong in 2004, when he sang the praises of adjustable-rate mortgages. He was wrong in 2005, when he dismissed the idea that there was a national housing bubble, suggesting that at most there was some “froth” in the market. He was wrong last fall, when he suggested that the worst of the housing slump was behind us. (Housing starts have fallen 30 percent since then.)

But his latest pronouncement — that the market rescue plan being pushed by Henry Paulson, the Treasury secretary, is likely to make things worse rather than better — looks all too accurate.

To understand why, we need to talk about the nature of the mess.

First of all, as I could have told you — actually, I did — there was indeed a huge national housing bubble.

What even those of us who realized that there was a bubble didn’t appreciate, however, was how much of a threat the bursting of that bubble would pose to financial markets.

Today, when a bank makes a home loan, it doesn’t hold on to it. Instead, it quickly sells the mortgage off to financial engineers, who chop up, repackage and resell home loans pretty much the way supermarkets chop up, repackage and resell meat.

It’s a business model that depends on trust. You don’t know anything about the cows that contributed body parts to your package of ground beef, so you have to trust the supermarket when it assures you that the beef is U.S.D.A. prime. You don’t know anything about the subprime mortgage loans that were sliced, diced and pureed to produce that mortgage-backed security, so you have to trust the seller — and the rating agency — when they assure you that it’s a AAA investment.

But in the case of housing-related investments, investors’ trust was betrayed. Supposedly safe investments suddenly turned into junk bonds when the housing bubble burst. High profits reported by hedge funds — profits that were reflected in huge payments to the fund managers — turn out to have been based on wishful thinking.

Thus, when two hedge funds run by Ralph Cioffi of Bear Stearns imploded last summer, it came as a huge shock to many investors, and helped trigger a market panic. But a recent BusinessWeek report shows that the funds were a disaster waiting to happen. The funds borrowed huge amounts, and invested the proceeds in questionable mortgage-backed securities.

Even worse, “more than 60 percent of their net worth was tied up in exotic securities whose reported value was estimated by Cioffi’s own team.” We’re profitable because we say we are — just trust us. That hasn’t ever caused problems, has it?

Stories like this have led to a crisis of confidence. The current yield on one-month U.S. government bills is only 3.41 percent, an amazingly low number, and a sign that people are parking their money in government debt because they don’t trust private borrowers. And the result is a shortage of liquidity — the ability to raise cash — that is greatly damaging the economy.

Which brings us to the rescue plan proposed by a group of large banks, with Mr. Paulson’s backing.

Right now the bleeding edge of the crisis in confidence involves worries that there may be large losses hidden inside so-called “structured investment vehicles” — basically hedge funds that borrow from the public and invest the proceeds in mortgage-backed securities. The new plan would create a “super-fund,” the Master Liquidity Enhancement Conduit, which would seek to restore confidence by, um, borrowing from the public and investing the proceeds in mortgage-backed securities.

The plan, in other words, looks like an attempt to solve the problem with smoke and mirrors.

That might work if there were no good reason for investors to be worried. But in this case, investors have very good reasons to worry: the bursting of the housing bubble means that someone, somewhere, has to accept several trillion dollars in losses. A significant part of these losses will fall on mortgage-backed securities. And given this reality, the “conduit” looks like a really bad idea.

I’d put it like this: Investors aren’t putting their money to work because they don’t know where the bad debts are. And when investors need clarity, the last thing you want to be doing is pumping out more smoke.

Mr. Greenspan’s take, expressed in an interview with the magazine Emerging Markets, seems broadly similar. “If you believe some form of artificial non-market force is propping up the market,” he said, “you don’t believe the market price has exhausted itself.”

Translated: this rescue scheme could be seen as an attempt to hide the bad debts everyone knows are out there, and as a result could delay any return of trust to the markets.

Alan Greenspan is making sense.


Wall Street Journal


The real-estate slowdown that hit the U.S. is spreading to Europe.

Home prices in some of Europe's hottest markets are falling after a decade of double-digit-percentage increases. The reasons resemble those across the Atlantic: higher interest rates, faltering confidence and tighter lending standards.

"A year ago it was all, 'no problem,' but now they're making us jump through hoops," said Iciar Caro, a 29-year-old school psychologist in Spain who can't find a bank to give her a mortgage on a €236,000 ($337,000) house in a northern suburb of Madrid.
[Rising More Slowly]

Home prices in Spain more than doubled over the past 10 years, but the average price of an existing home has fallen slightly since July, according to real-estate agent facilisimo.com. France experienced its first quarterly home-price decline in almost a decade in the third quarter, according to its federation of real-estate agents, while Irish house prices in August were 1.9% below the year-earlier level.

The weakening home market could hit European economies. An expanding construction industry has fueled growth in Europe. Now, construction in Spain and elsewhere is easing. Also, some people said higher payments on their mortgages are cutting into their ability to spend.

The housing boom was a global phenomenon, affecting virtually every developed country outside of Japan during the past 10 to 15 years. Former Federal Reserve Chairman Alan Greenspan is among those who argue that a period of sustained low interest rates and quiescent inflation world-wide after the Soviet Union's collapse encouraged a rush into housing.

Low interest rates were a potent stimulant in Spain, which experienced one of the biggest housing booms in Europe. The European Central Bank, mindful of slowly expanding, big economies on the Continent, kept interest rates low for much of the first part of the decade -- often lower than the rate of inflation in Spain. That encouraged Spaniards to borrow money.

Last year, Spanish families on average paid six times their annual salary to buy a home, compared with 3½ times salary in the late 1990s, according to the Bank of Spain, the central bank. Immigration and an influx of wealthy tourists scooping up coastal property fueled skyrocketing prices.

Construction accounts for about 10% of Spain's annual output, compared with about 7% in the U.S. Last year, 726,000 new homes were built in Spain -- more than France, Germany and Britain combined, even though those three countries together have more than five times as many people. Housing helped push Spain's economic growth to 3.9% last year, its fastest rate since 2000.

But the energy is fading. The Bank of Spain said new-housing permits fell 38% in July from the year-earlier period, the latest figures available, after falling more than 20% in May and June. Spanish central bank Gov. Miguel Ángel Fernández Ordóñez warned this month that the credit crunch and the housing slowdown would affect consumer spending next year. Car sales and consumer confidence already are turning south.

Rising interest rates headline the front pages of Spanish dailies, which update monthly mortgage-payment increases. Some 95% of Spanish mortgage holders have variable-rate loans.

The orange-and-black Se Vende, or for sale, signs that used to appear briefly on balconies of apartments for sale in Madrid now linger for weeks and months. At the same time, as the resale market softens, more Se Alquila, or for rent, signs are popping up in a country where renting has traditionally been a last resort.

Tomas Gonzalez, a 33-year-old translator, bought a spacious, three-bedroom apartment in downtown Madrid last fall, with help from his in-laws. He and his wife, a free-lance audiovisual producer, felt monthly payments of €800 on a 35-year, €200,000 loan were manageable. Now, the payments have risen €200 a month after the European Central Bank's gradual lifting of interest rates, which it began in 2005. Plus, the Gonzalezes fear their home is worth less than they paid for it. One set of neighbors have repeatedly cut the price of their home in a yearlong effort to sell.

Mr. Gonzalez has stopped eating out and curtailed his purchases of books and music. "We are trying to save something for the lean times ahead," he said.

On the consumer front, the euro zone has one difference from the U.S. that may soften the effects of flattening home prices. American consumers have used home-equity loans to turn the rising value of their homes into cash that can be spent on big-ticket items. In the 13 countries that share the euro, home-equity loans are rare. And Europe doesn't have a subprime sector comparable with the one in the U.S.

Ms. Caro, the psychologist, has signed a contract for a 600-square-foot house under construction in a northern Madrid suburb, where she hopes to live with her boyfriend. In Spain, buyers sometimes make a down payment gradually by putting in a little money each month. Ms. Caro has been doing so for 18 months, and she had hoped to pick up the keys in November.

Now, that hope may be dashed if she can't find a mortgage, or if the interest rate on a mortgage is too high. Ms. Caro has cut back her spending on vacations and clothes, and recently she began teaching private classes in the evenings to earn extra cash. She said she has stopped following interest rates "or I will go crazy."

In the third quarter, 22% of banks surveyed by the European Central Bank reported that they were tightening standards for mortgages, with 10% easing and the rest unchanged. Banks that raised the bar cited deteriorating bank balance sheets and weaker housing-market prospects.

"The ECB had already been raising rates to cool things down, and it was having an effect," said Ken Wattret, an economist with BNP Paribas SA in London. "Now, you've got this credit crunch on top of it, which could not only restrict households' access to funding but also slow the housing market more sharply."

In Ireland -- where economic growth, an influx of immigrants and low interest rates helped quadruple house prices over the last decade -- the boom also may be ending. Falling house prices will push construction of new units down to 60,000 in 2008 from last year's record 88,219, according to a recent study commissioned by Ireland's environment ministry.

Construction accounts for some 13% of Irish jobs, and the slowdown prompted the Economic and Social Research Institute in Dublin to reduce its forecast of Irish gross-domestic-product growth next year to 2.7% from 3.7%. David Duffy, a senior researcher at the institute, said: "It would still be a good growth outturn in a European context."

Some European countries experienced less of a housing boom and are feeling less of a hangover now. In Germany, the largest economy in Europe, a preference for renting has kept house-price growth limited. In an interview last week, German Finance Minister Peer Steinbrück listed cities, including London and New York, where he believes there might be a property bubble, and then added pointedly: "Not in Berlin."

In France, government regulation has limited construction, so French houses still are in short supply, unlike in Spain and Ireland. Also, the majority of French mortgages carry a fixed interest rate, meaning homeowners are less sensitive to rate increases. That is why economists expect any slowdown in French home prices to be gradual.

The variations across Europe complicate the ECB's rate-setting decisions. Earlier in the decade, its low interest rates were suitable for slowly expanding countries but helped foment the housing boom in high-inflation, high-growth countries. Now it is keeping rates higher, which may not be ideal for all 13 countries that use the euro. ECB officials have stressed that inflationary threats are likely to prevent them from cutting the bank's benchmark 4% rate soon.

During the boom, Spain and Ireland "needed higher interest rates, but the ECB was setting policy for France and Germany," said Desmond Lachman, an economist with the conservative American Enterprise Institute in Washington. "Now, when these countries need lower rates to offset the bust, they're not going to get them."