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Saturday, September 01, 2007

Lay the blame on Wall Street and Main Street

Lay the blame on Wall Street and Main Street
By John Authers
Copyright The Financial Times Limited 2007
Published: September 1 2007 03:00 | Last updated: September 1 2007 03:00

We all stand in the shoes of US mortgage-holders now. The financial system, we now know, relies on them. In recent weeks, a string of European banks has discovered that they had lent to US borrowers, as investment-grade securities they held turned out to be contaminated by bad US subprime mortgage bonds.

With the risk of US mortgage defaults now dispersed globally, not just Americans but everyone else in the developed world has an interest in averting an escalation in US defaults.

There is also a global search for culprits. Alas it turns out that almost nobody is blameless.

The importance of US housing is hard to overstate. For at least a year now, a central risk on investors' radar screens has been that falling house prices would force US consumers to spend less. That could cut global demand. Housing data this week was that US house prices were falling and the overhang of unsold properties was rising.

Further, the credit crunch in world financial markets and the slumping US housing market might easily reinforce each other.

Tighter credit conditions make it harder to obtain a mortgage, and hence reduce the demand for housing. But the recent popularity of variable loans, known in the US as adjustable-rate mortgages (ARMs), could also increase the borrowing costs for those who already hold a house.

That could raise defaults still higher while pushing house prices down - tightening the credit crunch and deepening the impact on the economy.

The loss of confidence in mortgage-backed bonds means that the increase in ARMs could be substantial - maybe as much as 2.5 percentage points. For borrowers who were stretched in the first place, and who only borrowed on the basis of generously low initial "teaser" rates, that could be critical.

Anthony Sanders, an economist at Arizona State University, suggests that a total of $500bn in variable mortgages is due to "reset" this year, with another $450bn next year.

The problem originated with "subprime" borrowers - who have poor credit histories - but now it is affecting the "prime" market as well.

He says that loans for investment properties, such as summer houses, are experiencing unprecedented defaults. Delinquencies in popular vacation states, such as Arizona and Florida, are running at unprecedented levels.

The blame does not all belong with Wall Street or with regulators. Rather, much of it belongs to old-fashioned human fallibility. Otherwise highly-intelligent and rational people lose their grasp of reality when the subject is house prices.

Robert Shiller - the Yale University economist famous for his 2000 book Irrational Exuberance, which predicted that the tech bubble would burst - has written a chapter on housing for the second edition of the book. He believes the same factors are at work.

He shows that house prices have detached themselves from underlying rental values. Moreover, he suggests that house prices are more prone even than stock prices to irrational exuberance.

On housing, buyers get their information from widely-dispersed anecdotal evidence, biased towards "success stories". They also tend to look at the return on housing investment in terms of the raw profit made on the sale. They do not take the costs of renovations or mortgage interest into account, let alone inflation.

Nobody treats stocks this way. Share price performance is quoted in percentage terms. Indices are well publicised. So, understanding of their performance is relatively rational.

Memories are short, too. The current housing boom in the UK has taken place barely 15 years after the disaster of the early 1990s, when many homeowners were stranded in their houses by negative equity.

So Wall Street and Main Street share in the blame for the debacle. Sadly, the same applies to the central banks now charged with getting everyone else out of this mess.

The Bank of England egged on house price inflation in the UK with what now looks like a badly judged rate cut back in August 2005. The housing market had been calming before that cut.

Worse, the last two chairmen of the Federal Reserve actively cheered on the irrational exuberance in US housing.

Alan Greenspan, who stood down last year, gave ARMs a warm endorsement, and said that fixed-rate mortgages "effectively charge homeowners high fees for protection against rising interest rates and for the right to refinance". Those fees now look as though they would have been worth paying.

As for his successor Ben Bernanke, in 2005 he said that the US had "never had a decline in housing prices on a nationwide basis", and that rising house prices "largely reflect strong economic fundamentals", not a bubble.

In combination, then, they sent out a message to Americans not to protect against higher rates, and not to worry about the risk of falling house prices.

With hindsight, that was not good advice.


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