Wall Street JournalThe home has long been the bedrock asset of most American families. Now, its value has become the biggest question mark hanging over the global economy and financial system.
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.
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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.
The new financial system -- shifting risk from banks to securities markets -- has worked "pretty well" up until now, says former Federal Reserve Chairman Paul Volcker. "We're going to find out if it works well for a major-league crisis."
To ease the pain, the Federal Reserve has cut short-term interest rates twice and is expected to cut them further tomorrow. The Bush administration has also pressed for private-sector curative measures. First, it urged big banks to create a new entity to buy some mortgage-linked securities that don't have a ready market now. And a plan finalized last week calls for freezing interest payments on perhaps hundreds of thousands of qualifying homeowners whose mortgage notes are set to rise. Both ideas are controversial. They are hailed by some as well-conceived financial first aid and criticized by others as inadequate -- or an impediment to crisis resolution.
INTERVIEW EXCERPTS
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"There's no question that the Fed was remiss in the way they handled this. They are guided by a theory of the market which I think is false."
-- George Soros
• Read more excerpts from interviews with George Soros, Paul Volcker, William Seidman and Robert Shiller.
Veteran financiers see in the current episode a pattern consistent with classic financial manias: Investors' enthusiasm for an asset -- in this case U.S. houses -- drove up prices, attracted more capital and lifted prices to levels that preordained a fall. Home prices rose sharply elsewhere, too, including in the United Kingdom, parts of continental Europe and Australia. "Old fogies like me expected the bust to come earlier than it did," says George Soros, the 77-year-old chairman of Soros Fund Management. "A lot of us got tired waiting for it."
The Extent of the Crisis
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.
[Tale of Two Bubbles]
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."
Mortgages today are dispersed among banks as well as more than 11,000 investment pools, each of which may have hundreds, if not thousands, of investors. Many of those pools have been further repackaged into specialized funds known as structured investment vehicles and collateralized debt obligations, or SIVs and CDOs -- each of which have their own investors. That makes determining who owns the securities, what they are worth and the nature of the underlying collateral a tricky process.
David Barse of Third Avenue Management LLC, a New York investment firm specializing in distressed companies, is steering clear of CDOs for now. He says he would need to hire new experts just to figure how much they are worth. "We don't have the analytical systems to break them down," he says.
Indeed, coming up with a value for a CDO entails analyzing more than 100 separate securities, each of which contains several thousand individual loans -- a feat that, if done on any scale, can require millions of dollars in computing power alone.
Recent deals, such as a hedge fund's purchase of the mortgage portfolio of E*Trade Financial Corp., suggest markets are starting to sort things out. But many investors are hanging back, prolonging the uncertainty over markets and the economy.
Housing fits a pattern Mr. Soros has observed since he entered the investment business in the 1960s. Economic fundamentals, he posits, are supposed to determine asset prices. But often a flood of capital makes an asset's fundamentals seem sounder than they really are, attracting even more capital. "Eventually, you reach a turning point," he says, "where the value of the collateral begins to decline, which reduces the willingness to lend, which reinforces the fall in the value of the collateral."
"There usually has to be a flaw in people's perceptions to set a boom-bust sequence into motion," Mr. Soros says. In the case of housing, he says, it was the assumption that, because home prices fall nationwide only in a severe economic slump, a diversified portfolio of U.S. mortgages made for a very safe investment.
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.
Chris Delzio, a securities broker in the pricier New York area, moved to Palm Bay, Fla., in 2003 and bought two town houses, each for $75,000. Within two years, he had sold both for double what he paid and plowed the profits into land to build five new homes. Compared to staring at a securities-trading screen, he says, "It was fun, driving around, looking at the properties. You're out, talking, negotiating."
Buying Time
When the Fed began to raise interest rates in 2004, mortgage rates also began to climb. Initially, home prices kept rising as home buyers turned to mortgages with low initial payments, assuming they could sell or refinance before the mortgage rate adjusted higher. Borrowers who had trouble making payments could easily buy more time by refinancing into bigger loans, thanks to higher prices. That kept defaults low and encouraged rating agencies to continue blessing securities backed by such mortgages with high ratings.
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Then, in places like Florida, buyers stopped coming. Mr. Delzio listed one home, on which he spent $203,000, at $210,000. He then cut the price repeatedly, finally to $175,000, barely more than the mortgage. He now rents it for $800 month, well short of the $1,400 monthly carrying cost.
Selling is made all the more difficult by the ample supply of homes and vacant land for sale in the area. Nationally, there were 2.1 million vacant homes for sale in the third quarter, equal to 1.6% of all the homes in the country -- a record.
At the end of 2006, the value of all homes in the U.S., excluding rentals, peaked at 153% of gross domestic product (or about $21 trillion) -- the highest level in at least six decades. By Sept. 30, that had edged down to 150% of GDP as home prices began to drop. With huge inventories of unsold homes soon to swell with foreclosed properties, that is likely to continue.
Falling home prices make consumers poorer and less ready to spend, and they make it harder to borrow against home values -- even if consumers are current on their payments.
Surrounded by Foreclosure
The downturn is particularly tough on those surrounded by foreclosed homes. Melissa Pohlman and her husband bought a renovated home in North Minneapolis's down-at-the-heels Jordan neighborhood three years ago for $205,000. It was most recently assessed by the city at $230,000. Ms. Pohlman, a 29-year-old pastor, hoped it would eventually rise to $240,000, at which point they would have enough equity to stop paying $160 a month for private mortgage insurance.
But hundreds of homes in the area are being foreclosed, and she doesn't even "want to know" what it is worth now. "You're dealing with an already transient neighborhood and then you heap on top of that a ton of foreclosures -- there are a lot of vacant homes, a lot of houses that are boarded up."
The pressure on homeowners is only part of the picture. A potentially bigger issue is the impact of this bad debt on banks and investors -- and their continued willingness to lend to consumers and businesses.
Mortgage securities typically consist of 10 or more different slices -- from highly rated slices for conservative investors all the way down to low-rated, riskier slices for investors looking for bigger returns. Each slice has its own set of rules governing when and how investors will get paid or suffer losses. Rising defaults can actually be good for some highly rated slices, which get paid off faster as a result. Many lower-rated slices, though, pay back the original investment only after three years, and only on the condition that defaults remain low. That means the value of a security issued in 2006 stands to be a big question mark until 2009.
"Maybe people will get wiped out, maybe they won't -- we won't know until two or three years from now," says Dan Castro, managing director at GSC Group, a New York-based asset-management firm that focuses on the mortgage market.
Ken Guy, finance director of King County, Wash., says the county's investment pool bought short-term IOUs called commercial paper backed by several SIVs because they appeared to be low risk. "We relied heavily on the ratings agencies," he says. About 10% of his $4.8 billion fund was invested in such paper. When the mortgage-backed assets held by the SIVs suddenly started going bad, some of his investments were downgraded all the way to "default."
"How could this have happened so quickly?" Mr. Guy wondered with colleagues. "How could these be downgraded from top to bottom in a day or two?" Such questions have been raised repeatedly.
"We've seen an unprecedented decline in market liquidity, really beyond what we thought possible," says Noel Kirnon, executive vice president in charge of structured finance at Moody's Investors Service, one of the two large ratings firms.
"Ratings on SIVs are significantly impacted by the market trends...even when the underlying portfolio maintains its credit quality," says a spokesman with Standard & Poor's, the other large ratings firm.
The complexity of mortgage-backed securities is making banks more vulnerable to losses than expected. It turns out banks didn't manage to shed so much of the risk of lending by packaging mortgage loans into securities and selling them to investors. Instead, they kept a large portion of the risk in various forms, including pieces of the CDOs they helped bring to market.
They also sometimes struck deals to provide emergency funding to SIVs and managers of CDOs -- obligations that weren't always clearly spelled out in their financial statements. Such agreements with CDO vehicles led to much of the $8 billion to $11 billion in write-downs that Citigroup Inc. says it expects to suffer in the current quarter.
With mortgage losses mounting, banks all over the world are shying away from risk. Swiss bank UBS AG recently announced four billion Swiss francs ($3.54 billion) in third-quarter losses on securities backed by U.S. mortgages and has warned of more to come in the current quarter. In one of a number of moves aimed at cutting back on risk, the chief executive, Marcel Rohner, has said he plans to slash the investment bank's assets by 30%, which means putting a lot less money into securities.
Because everyone from auto dealers to Main Street banks now depends on securities markets as a source of credit -- as opposed to banks -- such moves could make it more difficult for consumers and companies to get money.
Banks are also wary of lending to one another. They are trying to keep as much cash as possible as a cushion against potential losses, and they are worried that their counterparts could go belly up. As a result, they have been charging each other much higher interest rates. Those rates, in turn, affect monthly payments on millions of credit cards and mortgages in Europe and the U.S.
Asset prices stop falling when markets conclude that all the bad news has been factored in. At that point, so-called vulture investors pounce. But most are holding back because they think banks and SIVs could yet be forced to sell more of their holdings of subprime-backed securities into a market with few buyers.
'Littered with Corpses'
TCW Group, a Los Angeles asset-management firm, raised about $1.5 billion over the summer in anticipation of finding distressed opportunities in the mortgage market. But Jeffrey Gundlach, chief investment officer, says he has invested less than a quarter of those assets so far. "The 2007 capital markets are littered with corpses of the people who thought [subprime bonds] were a good buy at 90, 80, 70, 50, 40, 30 and 20 cents on the dollar," says Mr. Gundlach, a mortgage expert since the 1980s. He looks at 50 depressed mortgage bonds for every one he buys.
In spite of the gloom, the economy may avoid recession. Housing comprises a much smaller share of the economy than business investment, which dragged the U.S. into recession in 2001. Also, the rest of the world is stronger than in 2001, boosting U.S. exports. For the entire U.S. economy to contract would probably require a broad decline in consumer spending, which hasn't happened since 1991.
And, while financial problems are serious, they aren't -- at least yet -- on a par with those of the 1980s, when many major banks would have been insolvent had they valued their Third World loans accurately. There is, indeed, a possibility that the opacity of today's mortgage securities means markets may be factoring in far larger losses than will actually occur. Though the Fed is still worried about inflation, it has plenty of room to cushion the economy with additional interest-rate cuts.
But after years of living off the debt-financed increases in the value of their homes, U.S. consumers are in uncharted territory. "A lot of people, including me, have been saying that the country has been spending more than it's been producing, and that will have to come to an end," says Mr. Volcker. "The question is: Does it come to an end with a bang or whimper?"
