Fail-safe that wasn't

Investors seeking safety in housing encounter subprime crunch

Your Money

September 09, 2007|By Gail MarksJarvis

The problems in the housing market were supposed to stay there. Perhaps they would be a nightmare for some homeowners, but not for the economy in general.

Or at least that's what most of Wall Street was espousing until July. Yet, in the past eight weeks, it has become clear that their analysis was wrong.

Fear has brought to an end the easy-money conditions that homeowners and businesses have enjoyed for the past few years. Temporarily, at least, there is a credit crunch. Banks and other lenders are reluctant to make loans, and homeowners and businesses that want, or need, to borrow may have to pay a dear price to get money.

If fear lasts, analysts worry that the economy will slow, possibly going into a recession.

This is how the housing problem evolved into larger issues for the economy and investors.

In the beginning

The groundwork for the current problem was laid when the technology stock market bubble burst in 2000 and terrorist attacks followed in 2001.

To prevent a serious recession, the Federal Reserve lowered interest rates. The idea was to make borrowing money cheap.

It worked. Money flowed throughout the world. It made buying a home easy, and it stoked development from Asia to Latin America.

In the United States, individuals who became afraid of stocks looked for a new fail-safe investment. They turned to something solid -- homes. Families and home speculators poured money into housing, and the intense demand caused prices to soar.

"My neighbors used to talk to me about their stocks," said Minneapolis stock and bond analyst Jim Floyd amid the housing mania. "Now they only want to talk about their homes."

People were afraid not to buy the home of their dreams. They imagined prices going higher, pricing them out of the market. And they were enticed by the myth that homes always are a good investment.

Lenders offered exotic mortgages so that people would qualify immediately for loans, ones that they might not be able to afford later on.

The process was built on the assumption that home values would keep rising. And homeowners, mortgage lenders, Wall Street investment banks and financial institutions eventually paid the price of naivete or greed.

Homeowners' predicament

When a homeowner's affordable monthly payments ran out and were about to escalate, the person had an easy out as the housing market was booming. Interest rates were low, and housing prices were climbing, so it was simple to get a lender to refinance the home.

Homeowners with weak credit, so-called subprime borrowers, played the refinancing game over and over again.

Whenever mortgage rates adjusted to unaffordable monthly payments, they simply dumped the old loan and replaced it with a new one. They refinanced so they could lock in monthly payments they could afford for another one or two years.

But now they cannot get a reprieve from awful monthly payments: The low interest rates that made mortgages so cheap in the past are gone. And because so many people have homes they can't afford, they have been rushing to sell them. That has caused prices to stagnate or drop.

Some people are stuck, unable to refinance their home and unable to sell it at a price high enough to pay back the bank.

Many homes are worth less than what homeowners borrowed. And lenders won't dare refinance a mortgage for someone who owes more money than the home is worth.

This is causing a downward spiral in home prices. Desperate homeowners must sell their homes. And when lenders are foreclosing -- taking back homes that became unaffordable to homeowners -- they are selling homes, too.

There is a glut of homes on the market. Because the market is loaded down with homes, sellers often must cut the prices so they can attract buyers.

To make matters worse, lenders have become fearful about losing money on home loans. So they have changed the criteria for giving loans. Homebuyers who would have qualified for loans a couple of years ago can't meet the higher hurdles lenders are imposing. So there are more homes on the market and fewer buyers qualifying for the loans to buy them.

The escape hatch is closing tighter. More homeowners are getting stuck with payments they can't afford, more homes are going on the market, and home prices will continue to fall as the supply swells and people have trouble getting loans.

Bad mortgages take toll

As the home recession has deepened, the damage has shown up in the financial system throughout the world -- at BNP Paribas bank in France, hedge funds in Australia, some bond mutual funds in the United States and Wall Street dynamos such as Goldman Sachs and Bear Stearns.

All were investing in Wall Street creations that are fairly new, creations they thought were fairly safe but ended up being anything but. With those creations, securities with such names as collateralized debt obligations, banks changed their role in the mortgage business.

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