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Sub-prime shock waves

August 17, 2007 | Page 5

PETRINO DiLEO examines the factors under the surface of the recent turmoil on world financial markets.

IN EARLY August, after months of assurances by financial commentators that the crisis had been contained, the U.S. economy's sub-prime mortgage mess roared back to life and took down a new swath of victims.

Sub-prime mortgages--housing loans made at higher-than-normal and adjustable interest rates to borrowers with little credit or income--were a significant part of the U.S. housing boom of the past decade. But with housing prices starting to decline earlier this year, homeowners with sub-prime mortgages found themselves worse off several years into the loan--and facing the threat of foreclosure.

In recent weeks, big-name banks in Germany, France and Australia all announced they faced big potential losses from sub-prime loans gone bad in the U.S.--and that triggered big losses on world stock markets. Next, markets for business and commercial loans froze up.

To try to calm the financial markets, the U.S. Federal Reserve Bank pumped $59 billion into the system over two days. The European Central Bank released $130 billion--the largest infusion of capital since its formation.

In the U.S., the investment firm Bear Stearns has become the poster child for the crisis in sub-prime mortgages. Two of Bear Stearns' hedge funds that were heavily invested in sub-prime mortgages disintegrated, wiping out $1.6 billion in investors' assets in a matter of days. The firm's stock is down about 30 percent from the beginning of the year, and its co-president was forced to resign.

But as bad as things have gotten on Wall Street, the damage to homeowners is more severe. Defaults and delinquencies on mortgage loans are at their highest points in years. Many more people are facing the prospect of losing their homes and going through painful bankruptcies.

There have already been 1 million foreclosures in 2007, and the count could reach 2 million by the end of the year. An estimated 110 mortgage lenders have imploded, and the troubles have spread beyond sub-prime mortgages to so-called Alt-A mortgages (a notch below the top-rated, or prime market) and even to the prime market itself.

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WHY IS Wall Street so spooked by a crisis that's largely been talked about in terms of sub-prime mortgages--a relatively small piece of the overall mortgage market?

Because the sub-prime crisis is just one piece of a huge credit bubble. As Jim Rogers, chairman of Beeland Interests Inc., put it, "This was one of the biggest bubbles we've ever had in credit."

Perhaps the culprit most to blame for the current mess is former Federal Reserve Chair and neoliberal demigod Alan Greenspan, who responded to a series of economic shocks by lowering interest rates and pumping dollars into the economy to create "easy money" conditions.

With the 1997 collapse of the so-called Asian Tiger economies, the Russian loan default crisis the following year, the bailout of the Long Term Capital Management hedge fund and the implosion of the technology stock market bubble at the turn of the decade, Greenspan eased interest rates as a way of stimulating the economy to ride out each storm.

By 2003, Greenspan had cut the Federal Reserve's benchmark overnight interest rate--which sets the standard for many other kinds of debt--to 1 percent, the lowest level in decades.

According to the Wall Street Journal, Greenspan himself worried about the ramifications of his actions. "I don't know what it is, but we're doing some damage, because this is not the way credit markets should operate," Greenspan said.

That "damage" is becoming obvious today.

Record-low interest rates encouraged massive borrowing and, in turn, a search for ways to put this capital--as well as the proceeds from George Bush's huge tax cuts for the wealthy--in motion. Fresh from being burned by the stock market downturn, investors turned their attention to the bond market and to private equity funds and hedge funds--entities that in turn borrowed heavily when making their investments.

The new boom area was in "structured products"--a fancy name for Wall Street's creative packaging of all kinds of debts into securities that could be bought and sold. Banks rolled together riskier mortgage debts with more stable ones to create securities that were given AAA ratings by credit agencies--essentially a statement that buying them was as safe as buying U.S. Treasury bonds, despite their sub-prime component.

Other debt--student and auto loans, credit card debt and all kinds of corporate debt--got the same treatment. What emerged was a veritable alphabet soup--CDOs, CLOs, CMOs, RMBS, CMBS--of different debt-backed securities, all available for investors to buy and trade.

The booming market encouraged more and more risk-taking--and drew growing numbers of investors. Banks came under mounting pressure to find more mortgages, as well as other kinds of debt, to repackage and sell as securities. By the end of the first three months of 2007, the total value of all outstanding securitized debt was $28 trillion--more than double the figure of 10 years ago.

At first, banks were content to make or buy loans, package them together, sell them as bonds and get their returns through fees. However, they eventually decided to get in on the action themselves--starting up their own hedge and private equity funds that invested in mortgage- and debt-backed bonds.

One of the supposed benefits of securitization is that it spreads the risk around. But in practice, as loans have gone bad, the effects have been far-reaching and hard to predict--thus, the shock in the financial markets every time a new bank comes forward to admit it's in trouble.

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WHAT WAS the effect beyond Wall Street? Faced with the most generous mortgage terms in a generation, more Americans were able to buy homes. But it didn't stop there.

As housing values began to rise, growing numbers of people began "flipping" houses--purchasing them and reselling them quickly for a higher price--or buying second homes. Others took advantage of rising housing values to refinance and take "equity" out of their homes, spending the extra cash on consumption in lieu of wage gains.

The fact that it was so easy to get mortgage financing created a crush of buyers--which couldn't help but drive housing prices up.

The final straw was the proliferation of the sub-prime market. In 1996, lenders made just $60 billion in mortgage loans that didn't meet "prime" standards. In 2005 and 2006, the sub-prime market was worth more than $600 billion each year.

But what's striking now is that along with the tremors in the sub-prime mortgage market, the market for corporate bonds--debt taken on by big business--has also ground to a halt.

According to the Wall Street Journal, 46 mergers and acquisitions worth $60 billion have fallen apart since late June. The market for corporate bonds has nearly vanished--with an estimated backlog of between $200 and $300 billion in unsold bonds that investors won't touch.

All this is the predictable product of the deflating housing bubble. Even Greenspan took action to overcome this looming problem, raising the Fed's benchmark interest rate from the low point of 1 percent to the current 5.25 percent.

But housing values kept rising at double-digit rates, peaking in 2005 and 2006, depending on the market. It was only a matter of time before loans started coming due that people couldn't pay. And despite all claims to the contrary, the contagion is spreading.

The result is a credit squeeze. Investors who a year ago were gobbling up every form of securitized debt that Wall Street could offer are now balking at buying loans they view as risky. As a result, lenders have had to tighten their terms and conditions for making loans.

It's difficult to say how this will play out. The Federal Reserve's infusion of capital in early August was also a sign that that the bank's new chair, Ben Bernanke, may be prepared to intervene.

There have been rumblings that the government-sponsored housing giants Freddie Mac and Fannie Mae will be freed up to buy defaulting mortgages and offer refinancing to families faced with losing their homes. So far, though, working-class homeowners are bearing the brunt of foreclosures.

It's impossible to predict how far the credit crisis will spread, and what sectors will be affected. For now, the U.S. economy is still growing, and unemployment remains relatively low. The world economy has chalked up its fastest growth in more than 30 years.

However, the credit squeeze could spread and choke off the economic expansion--in the U.S. and around the world. Suddenly, the possibility of a recession is looking a whole lot more likely.

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