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Fail-safe that wasn't

The Baltimore Sun

The problems in the housing market were supposed to stay there. Perhaps they would be a nightmare for some homeowners, but not for the economy in general.

Or at least that's what most of Wall Street was espousing until July. Yet, in the past eight weeks, it has become clear that their analysis was wrong.

Fear has brought to an end the easy-money conditions that homeowners and businesses have enjoyed for the past few years. Temporarily, at least, there is a credit crunch. Banks and other lenders are reluctant to make loans, and homeowners and businesses that want, or need, to borrow may have to pay a dear price to get money.

If fear lasts, analysts worry that the economy will slow, possibly going into a recession.

This is how the housing problem evolved into larger issues for the economy and investors.

In the beginning

The groundwork for the current problem was laid when the technology stock market bubble burst in 2000 and terrorist attacks followed in 2001.

To prevent a serious recession, the Federal Reserve lowered interest rates. The idea was to make borrowing money cheap.

It worked. Money flowed throughout the world. It made buying a home easy, and it stoked development from Asia to Latin America.

In the United States, individuals who became afraid of stocks looked for a new fail-safe investment. They turned to something solid -- homes. Families and home speculators poured money into housing, and the intense demand caused prices to soar.

"My neighbors used to talk to me about their stocks," said Minneapolis stock and bond analyst Jim Floyd amid the housing mania. "Now they only want to talk about their homes."

People were afraid not to buy the home of their dreams. They imagined prices going higher, pricing them out of the market. And they were enticed by the myth that homes always are a good investment.

Lenders offered exotic mortgages so that people would qualify immediately for loans, ones that they might not be able to afford later on.

The process was built on the assumption that home values would keep rising. And homeowners, mortgage lenders, Wall Street investment banks and financial institutions eventually paid the price of naivete or greed.

Homeowners' predicament

When a homeowner's affordable monthly payments ran out and were about to escalate, the person had an easy out as the housing market was booming. Interest rates were low, and housing prices were climbing, so it was simple to get a lender to refinance the home.

Homeowners with weak credit, so-called subprime borrowers, played the refinancing game over and over again.

Whenever mortgage rates adjusted to unaffordable monthly payments, they simply dumped the old loan and replaced it with a new one. They refinanced so they could lock in monthly payments they could afford for another one or two years.

But now they cannot get a reprieve from awful monthly payments: The low interest rates that made mortgages so cheap in the past are gone. And because so many people have homes they can't afford, they have been rushing to sell them. That has caused prices to stagnate or drop.

Some people are stuck, unable to refinance their home and unable to sell it at a price high enough to pay back the bank.

Many homes are worth less than what homeowners borrowed. And lenders won't dare refinance a mortgage for someone who owes more money than the home is worth.

This is causing a downward spiral in home prices. Desperate homeowners must sell their homes. And when lenders are foreclosing -- taking back homes that became unaffordable to homeowners -- they are selling homes, too.

There is a glut of homes on the market. Because the market is loaded down with homes, sellers often must cut the prices so they can attract buyers.

To make matters worse, lenders have become fearful about losing money on home loans. So they have changed the criteria for giving loans. Homebuyers who would have qualified for loans a couple of years ago can't meet the higher hurdles lenders are imposing. So there are more homes on the market and fewer buyers qualifying for the loans to buy them.

The escape hatch is closing tighter. More homeowners are getting stuck with payments they can't afford, more homes are going on the market, and home prices will continue to fall as the supply swells and people have trouble getting loans.

Bad mortgages take toll

As the home recession has deepened, the damage has shown up in the financial system throughout the world -- at BNP Paribas bank in France, hedge funds in Australia, some bond mutual funds in the United States and Wall Street dynamos such as Goldman Sachs and Bear Stearns.

All were investing in Wall Street creations that are fairly new, creations they thought were fairly safe but ended up being anything but. With those creations, securities with such names as collateralized debt obligations, banks changed their role in the mortgage business.

They once lent money to individuals and collected payments over 30 years. But with the new securities, banks lent money and then sold the loans to firms that bought huge quantities of mortgages.

Those firms, in effect, threw multiple mortgages into a blender and made a brew and poured it out into bite-size pieces that investors bought. The investors bought them to get paid interest, which came from homeowners making their mortgage payments on time.

As thousands of homeowners began suffocating under loans they couldn't afford, they missed, or defaulted, on their mortgage payments. The brew that Wall Street concocted out of mortgages had turned bad. Investors such as hedge funds, banks, mutual funds, insurance companies and pension funds throughout the world started losing money on mortgage-backed securities.

Fear started to spread. The securities became viewed as hot potatoes in investment portfolios. Because Wall Street wizards never understood that their creations would crumble in a housing downturn, there is no reliable model to judge the investments, and no one trusts those investments now.

Merrill Lynch economist David Rosenberg said no one knows how big the losses are going to be.

"Nobody knows which banks or funds are sitting on losses, and, as a result, lenders are refusing to lend," he said.

Lenders don't give money if they are afraid it will go to a client with a financial mess that might bubble to the surface later and keep them from repaying the loan. They also won't lend if they have made the mistake of doing so to borrowers who cannot repay loans, or if they are holding a lot of tainted mortgage securities themselves.

Credit crunch

The extent of the worry within financial markets showed up prominently in August in what is called the commercial paper market. It provided a sign of a credit crunch.

Credit crunches are a fearsome problem for an economy. When they happen, it means people and businesses have trouble borrowing money. So the economy slows.

Commercial paper is one important way that businesses borrow money. When a bank, financial company or industrial company needs money on a short-term basis, it might sell commercial paper. In effect, an investor lends money to the business, and the business agrees to repay the investor with interest.

But the system has frozen up the past few weeks. Potential lenders started to worry about commercial paper that could be tainted by mortgage-related problems. So they became reluctant to buy it.

That is what is called a credit squeeze, maybe a short-term problem for borrowers that will dissipate when lenders become less fearful. But if difficulty borrowing money remains and spreads to other kinds of loans, the squeeze could become a credit crunch that slows the economy.

Regardless of whether there is a credit crunch for business, the housing market downturn is taking a toll on the consumer.

At the peak of the refinancing craze in 2005, homeowners pulled about $900 billion out of their homes, spending much of it.

Now, cheap money is no longer available, and people are stuck with loans they can't repay. Under such circumstances, people are reluctant to go on a shopping spree. And more than two-thirds of the U.S. economy depends on individuals to buy a wide range of products, from cars to clothing.

"Anyone who says that the housing market has not spread to the consumer sector would have to answer for how it is that auto sales in July fell for an unprecedented seventh month in a row," Rosenberg said.

"We may be on the precipice of the first consumer-led downturn in 17 years."

Gail MarksJarvis is a Your Money columnist.

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