Raise the Hammer
With mortgage foreclosures spiking and the subprime mortgage disaster unfolding (thirty lenders are already bankrupt with more to come), the damage is spreading as foreclosures and outright home abandonments rise among homeowners with adjustable rate mortgages as higher interest rates raise monthly mortgage bills beyond homeowners' ability to pay.
"This isn't just subprime," said Christopher Thornberg, an economist with the consulting firm Beacon Economics in Los Angeles. "This problem is starting to occur in most of the adjustable-rate mortgages. Even for prime borrowers, we're seeing a big spike in delinquencies among adjustable-rate mortgages."
Credit counselors are reporting a huge rise in calls from desperate homeowners, especially in the badly-hit industrial northern Midwest.
In response, the US Federal Reserve is hinting that it might lower the prime lending rate, prompting a rally in the jittery stock market.
After the NASDAQ collapse in 2001 when the bubble in high tech stocks burst, the Fed moved quickly to lower interest rates dramatically to forestall a serious recession. With amazingly cheap credit (at one point, the prime rate was effectively zero percent), demand for housing exploded as more people could suddenly afford a mortgage.
This boom in demand for houses started to push up house prices and triggered a boom in new construction. The rising values of existing houses attracted more people to get in on the act and "invest" in a house with a rising value.
Lending agencies got in on the act by offering outlandish mortgage terms - adjustable mortgage rates, no money down, 'no-doc' mortgages (borrowers do not have to present proof of income) and negative amortization (monthly payments for the first year are less than the accrued interest, so the total mortgage actually grows), all predicated on the assumption that continually rising house prices would keep these people afloat.
Lenders also aggressively pushed home equity lines of credit; homeowners could borrow against the rising value of their houses to pay for new cars, vacations, furniture, and so on. As a result, a person could take out a $300,000 mortgage in 2001 and end up with a $500,000 mortgage in 2006 on the same house.
(If you're wondering why no one questioned how the lenders thought they could get away with these irresponsible tactics, you may take a small measure of solace in the fact that now, after it's too late to make a difference, the SEC is investigating the business practices that left these companies so exposed.)
However, at the same time the Fed was holding credit at such a low rate, other forces were driving rising inflation rates. The easy money policy, combined with high energy prices over the past few years, have raised prices across the board.
Despite its efforts to stimulate the economy after the dot com bubble, the Fed is biased toward holding inflation in line by raising interest rates to slow demand growth.
As interest rates have crept up by tiny increments over the past two years, payments on all those adjustable rate mortgages have crept up as well. Because real median incomes in the US have been stagnant since 2000, this has pushed homeowners closer to foreclosure.
Ironically, until recently, many homeowners were able to stay afloat by using home equity lines of credit to cover their rising monthly payments, increasing their total indebtedness even as they pushed back the day of reckoning.
The housing bubble peaked in 2006, and house prices have been falling since. Without the cushion of rising equity, the day of reckoning is starting to arrive for those millions of homeowners in over their heads. The "magic equity machines" have lost their magic.
The Fed has softened its stance somewhat on tightening rates, but it's still unclear if a) this will actually translate into a rate cut, and b) a rate cut at this point would make much difference.
In addition to the millions of homeowners at risk of foreclosure, Wall Street is on precarious ground as well. For several years, a growing business has seen lenders sell mortgages to investment firms, which package all those mortgages into securities at various rates of risk and return.
This allowed lenders to increase the amount of mortgages they can sell and created a bonanza on Wall Street worth trillions of dollars. It also created a growing demand for more mortgages, which helped fuel the bubble.
So far, Wall Street insists the situation is under control, but with the amount of money at stake and the risk of a self-fulfilling prophecy, it's not surprising that investment houses are rushing to allay investor fears.
Sanford C. Bernstein's Brad Hintz acknowledged that Wall Street dodged bullets from the subprime crisis in the first quarter and will likely thrive by buying and trading the distressed loans, but was ... concerned by the lack of disclosure [of how much revenue is mortgage based].
"If the crisis spreads to other asset classes or the broader U.S. economy, the effect of this modest sector can be much greater and can impact many other businesses and asset classes," he wrote clients on Friday. "Unfortunately, investors will not know the ultimate impact of the sub-prime market problems until the slow-motion train wreck of rising mortgage delinquencies and defaults is played out over the rest of this year."
In any case, it's unlikely the troubles will stay inside the subprime sandbox. For one thing, many prime mortgages on adjustable rates are also at risk. For another, each foreclosed or abandoned house increases the supply of properties and lowers the average price for other homeowners, dragging yet more homeowners in to trouble.
How much longer can the Fed strategy of maintaining low interest rates keep the credit bubble afloat? Will this latest tweak even make a difference to the millions of homeowners teetering on the edge of foreclosure, or will it simply drag the mess out for even longer?
Saddest of all, perhaps, is the likelihood that, if and when the worm finally does turn, we can expect another public bailout to save the asses of the banks that parlayed high risk mortgages into trillions of dollars in irresponsible derivatives plays - while leaving the homeowners themselves to the wolves.
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