Who could have foreseen the housing bubble? And its malodorous bursting? Well, San Diegans, certainly, should have seen it, and some did: until late 2005, home prices had soared beyond anybody’s imagination as buyers grabbed for exotic mortgages that doomed families to future payments they couldn’t afford. And San Diegans weren’t virgins: they had just been through the bursting of the high-tech stock market bubble of the 2000–2002 period. Silicon Valley suffered a worse stock-bubble bursting, and real estate later went even crazier. Now the silicon chips are falling where they may — in the sewer system.
In San Diego, homes of 900 square feet with holes in their roofs and mold in their walls were going for more than $400,000. Wasn’t that a sign of insanity?
Anybody with an ear to the ground knew of the widespread fraud in the mortgage market. To get a mortgage, people didn’t need income, assets, a credit card, or enough money for a down payment. They just had to know how to tell a fib. Those selling the mortgages — who otherwise would have been peddling pencils on the street — loved those liar loans. They reduced the paperwork, so the peddlers had more time to round up suckers. And loans whose monthly payments were wired to escalate in the future were pawned off on borrowers who could have qualified for reasonable, lower-rate mortgages.
But why should the mortgage originators have cared if the loans were stinkers? As fast as they wrote the liar and predatory loans, they sold them off. Wall Street, figuring that home prices would never fall and people would always make their mortgage payments, bundled the mortgages into collateralized debt obligations (CDOs) and sold them to investors (well, gamblers, but they didn’t know it at the time). These bonds contained good and smelly mortgages alike — yet the bond-rating agencies gave them their highest AAA ratings. It was like mixing ground stinkweed with ice cream and selling a wondrous new gelato for ten times the standard price.
Wall Street came up with $2 trillion worth of this gelato, and much of it was peddled overseas. Understandably, the buyers, holding paper that might be worthless, want to sue U.S. financial institutions. The legal morass could get putrid enough to set off a banking crisis comparable to that of the 1930s, although that is a very remote possibility. To shelter the big U.S. banks, Treasury Secretary Henry Paulson wants a temporary interest rate freeze on a limited number of subprime, or lower-quality, loans. It’s being sold as a plan to rescue consumers from foreclosure, but if you believe that, you deserve to dine on skunk secretion. The Paulson plan’s purpose is to shelter the banks from some lawsuits. Supposedly, various rescue plans won’t nick taxpayers. Ha ha.
So how bad will this crisis be? Certainly, it could prove to be as deleterious as the savings and loan crunch of the late 1980s and early 1990s and the stock market crash of 2000–2002. Or worse.
“It is a big worry,” says economist James Hamilton of the University of California, San Diego. There were heavy delinquencies when the economy was quite strong. “So what happens if we have a recession? We don’t know, but it could be scary.” Hamilton, who specializes in the study of both housing and economic downturns, is not yet ready to declare that we are headed for a recession.
But his fellow economics professor at UCSD, Ross Starr, is more pessimistic. “This is probably the most depressed housing market the U.S. has seen since the 1930s,” says Starr. “It is a big deal. It will almost certainly lead the economy into recession in 2008” as residential construction, a key component of total economic output, sinks even further. “Residential construction is going to be at its lowest in decades for 2008 and 2009.”
Says Starr, “Part of this was foreseeable. But what was not foreseeable was the credit crunch that has come with it. Nobody knows the value of CDOs.” With so much uncertainty, loans are not available for many purposes. The Federal Reserve will continue to cut interest rates and add new relief wrinkles, but inflation is rising rapidly and the dollar is falling. The Fed may not be able to drop interest rates down to 1 percent, as it began doing early in the decade — providing the helium for the housing bubble. “The crisis will become worse if homeowners are forced to sell en masse in distress. The foreclosure process is a costly one not only for those who lose homes but for the creditors.”
Says Hamilton, “There are potential big losses” on government-sponsored enterprises such as Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), which buy mortgages and sell them on the open market. Will the government be forced to prop up Fannie and Freddie? “We shouldn’t be pretending that everything will be okay if we have some kind of guarantee. We should be honest with taxpayers about the obligation they are assuming.” That’s especially true now that conservatives are even talking about a government bailout.
And what about the bond-rating agencies that gave all this rancid gelato those AAA ratings? Frank Partnoy, law professor at the University of San Diego, wrote a research paper last year shedding light on these operations such as Standard & Poor’s, Moody’s, and Fitch. The rating agencies issued bullish reports on Enron right up until it collapsed, generally accepting at face value whatever the company said. The same was true with other corporate disasters such as WorldCom and Global Crossing. The agencies missed San Diego’s collapse too — issuing tough reports only after the City itself confessed that pension system liabilities were horrendous.
These agencies have a startling conflict of interest: “Approximately 90 percent of rating agency revenues come from issuers who pay for ratings,” said Partnoy in his study. Is it any surprise that ratings are skewed to the optimistic? The typical Wall Street securities analyst, also chronically overoptimistic, dangles the prospect of favorable ratings to snag future fees. But the rating agency “threatens the issuer with unfavorable ratings to obtain fees now,” according to the report.