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The Consequences of Mortgage Madness by J. F. Kelly, Jr. 8/10/07

The dog days of summer are usually dull days for the securities markets. Not this year, as you may already have noticed. The markets have been roiled by the bursting U.S. real estate bubble and the virtual collapse of the U.S. housing and mortgage markets. Can anyone honestly say that it was unexpected? How could market values which accelerated so rapidly and for so long not be vulnerable to a major correction? And how could a mortgage industry that made it possible even for someone with no savings, no verifiable income and in some cases no job to obtain a so-called no document loan expect the party to last forever?

Rapid and dramatic appreciation generated greed and encouraged speculation among buyers, builders and lenders. Everyone, including foreign investors, wanted a piece of the action and downplayed the risks. Borrowers agreed to take on risky adjustable rate loans, interest only loans and bizarre “creative” loan products. There was a loan product for almost everyone, regardless of credit risk and lenders were eager to promote them, each party betting that market values would continue to rise, permitting borrowers to refinance and lenders to earn more fees.

Builders speculated as well, overbuilding as builders invariably do in boom times. The glut of homes that resulted caused market values to fall, often below what was owed to lenders, dashing refinancing plans. Meanwhile, adjustable rates readjusted upward, forcing an increasing number of homeowners to default, adding bank foreclosed properties to the existing glut, further depressing market values and compounding a growing problem.

There is nothing wrong with trying to cash in on a speculative boom if one is prepared to absorb the market and credit risks involved. However, it’s obvious from the defaults, foreclosures and bankruptcies that many buyers and lenders were not. They shouldn’t expect a bailout because they knew or should have known that it was inevitable that this boom, like all booms, had to end eventually. Those homeowners faced with unaffordable increases in their adjustable rate loans deserve sympathy. They gambled on market prices rising and they lost. On the other hand, those who bought homes with nothing down really had nothing invested to lose. For all but the most naïve, the bursting of the real estate bubble should not have been a surprise.

What is surprising, however, is the global reach of the mortgage meltdown. A major French bank, which only a week before had said it had little exposure to the U.S. mortgage market, suddenly discovered that, in fact, it did, freezing over $2 billion in three hedge funds because there was virtually no market for the U.S. mortgage-backed securities these funds held. Why the belated realization? Apparently because this bank and other foreign banks held more U.S. mortgage-backed securities in their complex investment portfolios than they realized and because of the turbulence, it was difficult to determine from day to day what they were actually worth. This was followed by a similar event in Germany and the nervousness quickly spread to other world financial markets, sending stock prices down in the U.S. and Europe and threatening a world-wide credit crunch. Central banks, including our own Federal Reserve, responded by infusing billions into money markets to prevent it and to calm markets fearful of its effect on economic growth.

What does all this mean to ordinary Americans? Ours is a consumer driven economy. We spend and consume more when we feel financially secure and relatively wealthy. When our homes and investment portfolios decrease sharply in value, we are less inclined to spend discretionary income or savings and put off buying. Growing numbers of defaults in mortgage and credit card payments, resulting in an increasing number of non-performing loans, increase the cost of credit for individuals and eventually for businesses, forcing businesses to curtail expansion plans and eliminate jobs. The construction and mortgage industries are already hurting. The cumulative effect on the American economy can be severe and in this interrelated global economy that effect will spread, especially to those nations heavily dependant on U.S. consumer demand for their exports.

Naturally, Congress will try to ride to the rescue, perhaps making matters worse. Already presidential candidate Hillary Clinton has proposed a $1 billon bailout fund for homeowners facing foreclosure. But wouldn’t that simply encourage future speculative risk taking and pass on to taxpayers the cost of insuring against risk that the investor should bear? Senators Chris Dodd and Chuck Schumer called for Fannie Mae and Freddie Mac to ease borrowing restrictions and credit limits. But isn’t that what got us into trouble in the first place?

This crisis was entirely predictable and explainable by market forces. Perhaps the best approach is to allow those market forces to sort it out. Government intervention at taxpayer expense should be limited to measures that focus on minimizing the negative impact of the credit crunch on the economy, not on measures primarily designed to bail out those who gambled and lost in a speculative market with real and quantifiable risks. CRO

copyright 2007 J. F. Kelly, Jr.

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