House of Cards

...While there were a number of causes, one major factor is investor concern that problems in the subprime mortgage market—which caters to consumers with poor credit ratings—are going to spread...

...Some of the growth of subprime lending was a favorable development that put homeownership within reach for millions of lower-income people...

...In fact, the same risky practices (little or no down payment, no verification of income, high payments as a share of income, low teaser rates) began in the Alt-A market, a not-so-easytoquantify middle ground between subprime and prime borrowers...

...Even as the housing market has cooled, the price-to-income ratio and other common-sense metrics of home valuation are still off the charts...

...by Andrew Laperriere Last week the stock market experienced one of its largest drops since the 9/11 terrorist attacks...

...No one knows by how much, but these forces will lower growth and leave the economy vulnerable to recession...

...If it tries to bail out consumers, as some on Capitol Hill are contemplating, it might make the problem worse by giving homeowners, many of whom could muddle through without a bailout, perverse incentives (default and lower your mortgage payment...

...It is becoming increasingly clear that the housing boom was built on a weak foundation: easy money...

...In addition to the mortgage brokers and banks, the Wall Street firms that securitized these mortgages and the credit rating agencies that blessed their creditworthiness will make especially inviting political targets...

...The Center for Responsible Lending estimates that one in five subprime loans originated in the past two years will end in foreclosure...

...Another major factor: the insatiable demand by investors for mortgage-backed securities, which provided the funds for a fivefold expansion of subprime lending...

...Home prices are roughly flat nationwide in the last year, but, as the chart shows, the rate of appreciation is in free fall...

...The lower rates cut monthly payments, boosting demand for housing and pushing up home prices...

...But in the past couple of years, loans once known in industry parlance as “toxic waste” have become standard practice...

...Now that losses from bad subprime loans are climbing, investors in mortgage-backed securities are bailing out and banks are tightening their underwriting standards...

...So, fully 40 percent of mortgages originated in 2006 were risky...

...Despite low interest rates and an economy operating at essentially full employment, during the past few months subprime mortgage delinquencies have spiked to record territory...

...Critics call these so-called 2/28 loans “exploding ARMs...

...About two dozen subprime lenders have closed their doors, and the stocks of several major subprime lenders have plunged...

...It now costs half as much to rent as to own in the Mid-Atlantic and many other regions, powerful evidence that the market price of real estate is divorced from its underlying economic value...

...As home prices kept rising, loan terms became easier but fewer loans went bad, because homeowners in financial distress could usually refinance or sell their homes at a profit...

...If a bailout is less about debt relief and more oriented toward restructuring debt, it might drag out the downturn, just as the Japanese government’s efforts to insulate banks and businesses from bad loans delayed for years Japan’s recovery from its real estate bust...

...Fully 81 percent of Alt-A loans were extended with reduced or no documentation required from borrowers, according to First American LoanPerformance...

...The truth is, there is plenty of blame to go around, but there are not many productive policy options...

...Most subprime loans are 30-year adjustable rate mortgages (ARMs), but the interest rate resets after two years, and the payment rises significantly...

...What’s worse, the initial mortgage payment typically accounts for close to half of the borrower’s (nonverified) gross income—and even that high payment is based on a teaser rate...

...Policymakers need to proceed with caution...

...The boom started in earnest when the Federal Reserve slashed interest rates in response to the 2001 recession...

...The Federal Reserve went too far in cutting rates to cushion the economy from the fallout of the tech bubble, and today’s problems in the housing and mortgage markets are the unintended consequence...

...But the tighter credit conditions are only just beginning, so the worst of the economic fallout from the housing slump is probably ahead of us...

...If Congress tries to punish the lenders beyond the harsh penalty financial markets are likely to inflict, it will further discourage banks from making loans and will create a credit crunch...

...For example, borrowers with checkered credit histories have been able to buy a home with no down payment and no verification of income...

...After soaring the past few years, real estate prices in southern Florida, once the epicenter of the housing boom, have dropped in the past year by 6 percent in Miami and 18 percent in Sarasota-Bradenton, according to the National Association of Realtors...

...If, as the evidence strongly suggests, many consumers have taken out risky loans they cannot afford to pay back, then home prices will continue to drop, and significant financial hardship is largely unavoidable...

...Politicians won’t be inclined to blame consumers, but most home buyers knew—or should have known —that there is no free lunch...

...Because “subprime” borrowers have a less than stellar history of paying their bills on time, they pay a higher rate of interest, always alluring to investors with a stomach for risk...

...Confidence in everrising home prices and cheap money fueled speculation, which in turn boosted demand and pushed home prices higher still...

...Andrew Laperriere is a managing director in the Washington office of ISI Group, a Wall Street economic research and brokerage firm...

...The issue economists and investors are wrestling with is how much lower home prices and rising delinquencies will reduce employment, business investment, consumer spending, and overall economic growth...

...Therefore, the boom’s virtuous cycle (easy money, increased demand for housing, higher home prices, looser lending standards) is now reversing and becoming a vicious one (higher foreclosures, bigger losses for banks and investors, tighter credit standards, less demand for housing, lower home prices, still higher foreclosure rates...

...What’s going on...

...Credit bubbles that create these kinds of economic anomalies inevitably produce a financial train wreck, which is already happening in the subprime market...

...It’s already harder to get a risky loan—and about to get harder still— and these tighter credit conditions will reduce the demand for housing at a time when the inventory of homes for sale is near record levels...

...Given the relatively fixed supply of homes, the spike in demand fueled by risky mortgages was a key factor in the unprecedented increase in home prices...

...and “What can we do about it...

...Speculators who bought homes in the heady days of the boom started selling once the momentum turned, which, along with modestly higher interest rates, helped stop price appreciation in its tracks last year...

...His “Housing Bubble Trouble” appeared in our April 10, 2006 issue...

...But one also doesn’t have to sort through too many junk-mail solicitations to find unscrupulous lenders who misrepresented the risks of these loan products...

...This could lead to higher-than-expected foreclosures, job losses in construction and real estate, lower consumer spending, and possibly a recession...

...But the Fed’s loose monetary policy also created a credit bubble that led to today’s problems...

...The consumers who paid higher rates for “no doc” loans so they could fib about their income and qualify for a bigger mortgage, the speculators who gambled on Vegas condos, or borrowers who cashed out the equity in their home and exchanged their 30-year fixed rate mortgage for a “pay-option” ARM had to have known they were taking a risk...

...Inside Mortgage Finance, an industry publication, estimates that subprime loans accounted for 24 percent of the consumer market last year and another 16 percent were Alt-A loans...

...A better approach would have been to allow bankruptcies and a fresh start...

...What’s more, the bank regulators, who in this case were quicker to spot the problems than investors, have been tightening lending standards, and under pressure from Congress are in the process of tightening standards on subprime loans...

...But the lack of prudent lending standards hasn’t been confined to the subprime market...

...Naturally, as more and more families lose homes to foreclosure, two questions will increasingly be asked in Washington: “Whose fault is this...

...Unfortunately, there isn’t much Congress can do without making the problem worse or creating a significant moral hazard...