It hasn't reached us yet, but the tsunami is headed our way. The rest of the country has fallen into a housing slump that hasn't touched us here in western Washington so far. Yet even if our housing market continues to boom, we're going to feel the impact eventually.
The centerpiece of George Bush's economic recovery plan has been to provide cheap money to boost the economy. Cheap money is generated when the financial system provides easy, low-interest loans to consumers and businesses, allowing them to increase debt for everything from house and car purchases, to credit card debt, to loans for businesses. This is made possible by artificially depressing interest rates--keeping the bucks flowing in an economy that depends heavily on consumer spending for its growth.
In the past three years, most of our consumer spending has been fueled by low-interest home equity loans and mortgage refinances. Folks have been using their homes as ATMs. Instead of maintaining a stable, 30-year fixed rate mortgage, they've been refinancing into riskier adjustable rate mortgages (ARMs) that lower monthly mortgage payments and free up cash to spend--but only for a while. Once the rate adjustments kick in (in year two or three of their loans), their monthly mortgage payments soar and suddenly they find themselves struggling to keep houses they once thought they could afford. This wasn't a problem when housing prices were high and steadily increasing; these folks could always sell their homes and try again with a new house or, in some cases, refinance their old ARM into a new ARM.
Housing prices have plummeted in many parts of the country, leaving folks with ARMs in a real bind. If they sell their houses, they'll lose money and be unable to pay their debts. Nor can these folks refinance into new ARMs, because mortgage companies are presently unwilling to write risky ARMs. This is called "credit tightening." Too many people have defaulted on their loans causing banks and mortgage companies to lose money (more than 50 finance companies have gone bankrupt so far this year), so cheap money is harder to find now than in 2005 and 2006.
All the blame can't be shoveled onto the shoulders of consumers, however. Most folks who took out ARMs had no clue what they were getting themselves into, and that's at least partly the fault of the mortgage brokers and finance companies who wrote the loans. They make profit on the volume of loans and the total amount of money they lend, not on the quality of the loans they write. Sure, nobody wants a loan to go into default, but Wall Street has figured out a way to lessen the risk for mortgage lenders by packaging bundles of risky mortgage loans into mortgage-backed securities that can be sold to investors, thereby spreading the risk around.
Economists argued that by spreading risk the total financial impact is diluted if any of these risky loans fall into default. Credit rating agencies agreed. Of course, the rating agencies (Moody's, Standard & Poor's, Fitch's, etc.), are paid by the businesses who issue the bonds and securities they rate--a clear conflict of interest--so they routinely gave these mortgage-backed securities unwarranted high ratings. Investors, particularly those with pension fund investments and retirees searching for safe income-yielding investments, lined up in droves to buy these high-rated securities. Unfortunately, Wall Street couldn't have been more wrong.
By spreading the risk around, they inadvertently magnified the impact of mortgage defaults. This has been clearly illustrated by the wild market swings over the past couple of weeks, as investors quickly pulled their money out of any investment fund that might own mortgage-backed securities. In turn, these investment funds can't sell their mortgage-backed securities to pay their obligations to investors because nobody, simply nobody, is buying mortgage-backed securities. In other words, the market had dried up. Instead, investment funds have had to sell whatever assets they can to meet their debts to investors who want out of their funds. When they sold valuable stocks and commodities, the stock market plunged.
The story doesn't end here. Thus far, most mortgage defaults have been caused by sub-prime loans--the small part of the market comprised of people with poor credit histories. The bulk of folks who took out risky ARMs in 2005 and 2006 have yet to see their loan rates increase, a problem set to hit the market sometime in 2008. Nobody really knows how big this issue will be, though estimates range from $325 billion to $550 billion worth of loans that may default in the next year or two.
Of course all of this could have been averted if there was a regulating body keeping an eye on the mortgage industry, or making sure the credit rating agencies were doing their job properly. But the current fashion among US economists is to push for deregulation. Let the markets decide. Beware of government intervention, which stifles capitalism and profit. When the chaff is shaken out of the system, we'll all be better off, etc. Unfortunately, the chaff is comprised of people losing their homes, declaring bankruptcy, and becoming saddled with exorbitant debt. It's made up of people losing their jobs because of a housing slump and economic meltdown. It's made up of elderly people who've watched the value of their pensions and investments implode. To Wall Street, we're all chaff, and we ought to be pretty damn angry.
So what are the Bush administration and the Federal Reserve doing? When the crisis hit a couple of weeks ago, the Federal Reserve immediately poured billions of dollars into the banking system as more cheap money in a largely unsuccessful effort to keep credit flowing. Next the Fed cut the discount rate--the interest rate it charges on loans it gives to banks--by half a percentage point. Then the Fed opened its discount window to provide billions more to banks struggling to avoid declaring bankruptcy. Few banks and finance companies want to admit they have a problem by withdrawing money from the discount window. The negative publicity would drive down their stock prices, causing more financial woes. Last week four major banks, including Bank of America and Citigroup--none of whom are in any immediate financial trouble, by the way--lined up to withdraw a total of $2 billion from the Feds' discount window in a show of "good faith", as if to say, "See, there's no shame in dipping into the public trough when times are tough. Bailouts are a good thing."
Unless, of course, you're chaff. Then you're supposed to suffer in silence while Wall Street pockets its profits and gets rewarded for its mistakes.