Lending crisis: From Wall Street to Main Street to Your Street
By Chris O’Brien, Mark Schwanhausser and Sue McAllister
Mercury News
San Jose Mercury News
Article Launched:08/19/2007 01:35:38 AM PDT
As obscure financial crises go, the implosion of the subprime lending market last year seemed easy enough for most folks to ignore.
Then, this summer, the stock market went bonkers. It became more difficult to get a mortgage. And pundits started predicting that the economy was teetering on the brink of a full-scale meltdown that would lead to higher unemployment and interest rates.
Goodbye, blissful ignorance. Hello, high anxiety.
Now that the average Joe and Jane are paying attention, they have two simple questions: What happened? How bad is this going to be?
The answers lie in a convoluted tale that ricochets from the upper reaches of Wall Street to the Realtors’ shingle hanging on Main Street to the house that goes unsold on Your Street. At its essence, though, the crisis illustrates how the global economy has created an interconnected world where everyone’s fate is increasingly tied together.
“Unfortunately, the economy is like a spider web,” said Sung Won Sohn, president and chief executive of Hanmi Bank in Los Angeles. “I wish we could say that high finance is in a box over here. And the schoolteacher is in a box over there. But we’re all linked together now, and everything we do affects each other.”
The financial problems that burst into full view this year have been germinating for years. And there is no single villain. Big financial calamities usually require lots of players making lots of decisions that look foolhardy in retrospect.
Enough blame to go around
In this case, that includes lenders, investors, credit rating agencies, the Federal Reserve and, yes, lots and lots of home buyers desperate to own a piece of the American Dream.
Here’s what they were thinking.
Just after the dot-com bust in 2000, the stock markets plummeted. Over the next 18 months, the fallout dragged the economy to a standstill.
Enter the Federal Reserve. As the economy sputtered, the Fed cut interest rates to 40-year record lows. That cheap money spurred a housing boom that led to double-digit price increases from Sunnyvale to Miami. The mortgage industry could barely hire enough people to keep up with a wave of borrowing that led to soaring profits.
But no boom lasts forever. And eventually, to keep this one going, the mortgage industry began pitching exotic loans to borrowers with shaky finances. These loans - which in some cases may not have had credit ratings that accurately reflected their risk - were funded by Wall Street investors hungry for higher returns.
By stretching underwriting standards - and, eventually, consumers’ budgets - these exotic loans enabled millions of new borrowers to buy homes.
And that easy money allowed people with meager means to buy homes they once could only dream about.
As long as all, or almost all, of these new homeowners made all their payments, as long as the rate of defaults stayed low, as long as housing prices kept going up, everything would be fine.
The system was flawless. Until it wasn’t.
In June 2004, the central bank reversed course and raised interest rates. The economy seemed to be humming along. Companies were hiring. Stock prices were rising. Fed Chairman Alan Greenspan was now more worried about inflation.
It took some time, but mortgage rates crept higher. As adjustable-rate mortgages reset at higher rates, borrowers watched their monthly mortgage payments balloon. An alarming number of borrowers - some of whom did not have enough equity in their houses to be able to refinance or even sell - began to default.
Problems cascaded for the mortgage industry. Dozens of lenders went out of business. Home sales slowed. Housing prices fell in some places, flattened in others.
Boom on Wall Street
Many things contributed to the frenzy on Wall Street. The job market - led by financial services and construction - grew strong. Corporate profits rebounded robustly. And to boost their stock prices, companies spent billions of dollars to buy back their stock in hopes of making their shares even more valuable.
They say a light bulb burns brightest just before it burns out. On July 19, the Dow Jones industrial average closed at 14,000.41, an all-time record high.
But beneath this triumphant march, the foundation had eroded.
In July, two Bear Stearns hedge funds collapsed after having made big bets on bonds related to risky mortgages. Because hedge funds borrowed heavily to buy these bonds, falling bond prices quickly wiped out their collateral, forcing them to come up with cash to satisfy their own lenders. Fast.
But how?
"They don’t have the ability to say, `I will just hold on to it for a year and it will be better,’ " said Meir Statman, a finance professor at Santa Clara University. “A month is an eternity under those conditions.”
With the markets suddenly leery of riskier mortgages, hedge funds found it difficult to value their bonds, let alone find buyers. Rather than sell their mortgage-backed securities at fire-sale prices, they dumped stocks.
Goodbye, Dow 14,000.
In the past month, the Dow swooned, closing at 13,079.10 Friday. Along the way, it exhibited some wild mood swings.
The question is whether this will be a brief panic or the beginning of a deeper economic spiral. Where exactly will this stop?
“The markets are very fragile and unsettling. It’s no fun to look at your stock portfolio and see it deteriorate,” said Bill Kirsch, managing director of Costella Kirsch in Menlo Park. “It doesn’t feel like it will be a protracted event, but who knows?”
Some are betting the storm will abate soon. For example, Goldman Sachs lined up $3 billion last week to bail out one of its hobbled hedge funds, calling it a good investment opportunity.
Others, however, are flashing back to deeper financial downturns, notably the 1998 global recession that was sparked by an Asian currency meltdown, triggered a Russian financial crisis and endured the implosion of the massive Long Term Capital Management hedge fund.
So far, those most directly affected are home buyers and lenders.
Mortgage resets coming
It’s the housing market - already torpid in many parts of California and the nation - that is taking the biggest hits so far. In fact, many adjustable-rate mortgage rates have yet to reset, so the problems are likely to continue through 2008, according to First American Real Estate Solutions in Santa Ana. Lenders have pulled back on mortgage loans to all but the safest borrowers and clamped down on a range of riskier loans, which could slow things down even further.
The credit crunch has spread to commercial real estate. Last week, Silicon Valley land mogul Carl Berg announced that a $1.8 billion offer for his Mission West Properties portfolio had collapsed because the buyer’s financing had been pulled by the bank.
For the most part, economic indicators - from consumer spending to inflation rates - have remained strong.
“On the real economy side, the news is pretty good,” said Eugenio J. Aleman, senior economist for Wells Fargo. “Inflation, industrial production. Everything that came out says the real economy is doing well.”
But there is a psychological wild card that’s harder to measure. If consumers and businesses are nervous, will it cause them to pull back on their spending?
Friday, the Reuters/University of Michigan preliminary index of consumer sentiment fell to 83.3, a bigger drop than forecast and the lowest reading since August 2006, from 90.4 a month earlier. A measure of expectations also declined.
“It’s all psychological so far,” said Mark Zandi, chief economist for Moody’s Economy.com. “But if things don’t stabilize quickly, we’ll see businesses pull back on hiring, then possibly laying off people.”
Also Friday, the California Employment Development Department released its monthly jobs report that showed Silicon Valley lost 2,800 jobs in July, the first such dip this year, although much of the decline was seasonal.
In the coming weeks, Zandi said he will be watching reports from retailers and weekly filings for unemployment.
And once again, everyone is watching the Fed. Aug. 9, the Fed began pumping billions of dollars into the U.S. financial system to enable banks to continue making loans rather than conserving cash and exacerbating the credit crunch.
And Friday, the Fed cut one of its two key interest rates - the amount it charges for loans to banks. But there is still a desire by investors to see the Fed cut the other, more significant rate for loans that banks make to each other.
Deciding just how far the Fed and Chairman Ben Bernanke should go is a hotly debated issue.
Injecting money after the Sept. 11, 2001, terrorist attacks propped up the financial system, but cheap money also set the stage for the mortgage mess.
“The more rescues there are, the more idiot houses of cards get built,” said Richard Carlson, who heads Spectrum Economics in Palo Alto. “What Bernanke has to do is be sure that enough people get punished that this doesn’t happen again for a long time, but not punish so many people that it brings everyone down with them. That’s a very thin line.”
Contact Chris O’Brien at cobrien@mercurynews.com or (415) 298-0207.
