Endtime Economics

Editor: The newspapers are full of stories about the precarious state of the economy. Magazines and TV are too. Journalists and commentators and experts soberly discuss local, national, and world economic problems, debating what went wrong financially and how to fix it.

What did go wrong? In this "Endtime Economics" feature we'll examine some of the causes of the current financial crisis in relation to the housing downturn and mortgage mess, using news articles.

The articles or excerpts which follow often talk about the American economy or the economy of the West. We're not trying to be nationalistic or ignore the rest of the world. It's just that the major English-speaking news media are based in America and in Western Europe and are the source of much of this news.

Also, the economic issues we'll be discussing here—credit, debt, mortgages and more—are the same in almost every country and situation. So whether you're in the East, West, North or South, we trust you'll find at least some of this helpful and instructive.

Mortgages 

First, let's touch on what a mortgage is. Many of you already know this, but for the benefit of those who don't, World Book encyclopedia describes mortgages as follows:

A mortgage is a loan agreement that enables a person to borrow money to buy a house or other property. The property is used as security for the loan. The lender may take possession of the property if the loan is not repaid on time. A person can obtain a mortgage from a bank, insurance company, mortgage company, savings and loan association, or other financial institutions. Most mortgage agreements require the mortgager to repay the loan in monthly installments over a period of 20 years or more. Part of each payment goes toward the unpaid balance of the loan, called the principal, and part toward the interest. If the borrower misses a number of payments, the lender may foreclose the mortgage. Foreclosure is a legal procedure by which the lender takes over the mortgaged property. The lender then may sell the property, keep the amount owed, and give the borrower the rest [if any]. [Editor: Or, to put it very simply, a mortgage is when someone lends you money to buy a house, with the understanding that if you can't repay the loan, they'll repossess the house.]

A form of mortgage that's much in the news lately is what's called a subprime mortgage—a housing loan to those with poor or shaky credit. Author Bill Bonner describes one such case in his book Empire of Debt (John Wiley & Sons, Inc. 2006):

"My daughter is only twenty-five," wrote a friend, "but she just bought a house in Northern Virginia. Of course, she mortgaged most of it. But can you believe that they lent her $275,000? Is that crazy, or what? She works as a bartender, part time. She's very responsible, but I can't believe they would lend her that much money. How do they think she will pay it back?"

Cause and effect 

Why would banks encourage people to buy homes they can't afford, taking out loans they can't repay? And why would this sort of behavior have international repercussions? Journalist David Leonhardt explains in a New York Times article:

How is it that a mess concentrated in one part of the mortgage business—subprime loans—has frozen the credit markets, sent stock markets gyrating, caused the collapse of [the fifth largest investment bank] Bear Stearns, left the economy on the brink of the worst recession in a generation, and forced the Federal Reserve to take its boldest action since the Depression?

Let's go back to the beginning. It really started in 1998, when large numbers of people decided that real estate had become a bargain. At the same time, Wall Street was making it easier for buyers to get loans. It was transforming the mortgage business from a local one to a global one, in which investors from almost anywhere could pool money to lend.

Those same global investors demanded good returns. Wall Street had an answer: subprime mortgages.

Because these loans go to people stretching to afford a house, they come with higher interest rates—even if they're disguised by low initial rates—and thus higher returns. The mortgages were then sliced into pieces and bundled into investments, often known as collateralized debt obligations, or CDOs. Once bundled, different types of mortgages could be sold to different groups of investors.

Investors then increased their returns through leverage. They made $100 million bets with only $1 million of their own money and $99 million in debt. If the value of the investment rose to just $101 million, the investors would double their money.

Home buyers did the same thing, by putting little money down on new houses, notes Mark Zandi of Moody's Economy.com. The Fed under Alan Greenspan helped make it all possible, sharply reducing interest rates, to prevent a recession after the technology bust of 2000, and then keeping them low for several years.

All these investments, of course, were highly risky. Higher returns on investments almost always come with greater risk. But people—by "people," I'm referring here to Mr. Greenspan, Mr. Bernanke, the top executives of almost every Wall Street firm and a majority of American homeowners—decided that the usual rules didn't apply because home prices nationwide had never fallen before.

The American home seemed like such a sure bet that a huge portion of the global financial system ended up owning a piece of it. That left them on the hook when homeowners who had taken out a wishful-thinking mortgage could no longer get out of it by flipping their house for a profit.

Many of these bets [by banks and other investors] were not huge, but were so highly leveraged that any losses became magnified. If that $100 million investment I described above were to lose just $1 million of its value, the investor who put up only $1 million would lose everything.

"If anything goes awry, these dominoes fall very fast," said Charles R. Morris, a former banker who tells the story of the crisis in a new book, The Trillion Dollar Meltdown.

This toxic combination of bad investments and their potential to mushroom has shocked Wall Street into a state of deep conservatism. The soundness of any investment firm depends largely on other firms having confidence that it has real assets standing behind its bets. So firms are now hoarding cash instead of lending it, until they understand how bad the housing crash will become and how exposed to it they are. Any institution that seems to have a high-risk portfolio [set of investments], regardless of whether it has enough assets to support the portfolio, faces the double whammy of investors demanding their money back and lenders shutting the door in their face. Goodbye, Bear Stearns.

The conservatism has gone so far that it's affecting many solid would-be borrowers, which, in turn, is hurting the broader economy and aggravating Wall Street's fears.

Bubbles lead to busts. Busts lead to panics. And panics can lead to long, deep economic downturns.

How could subprime mortgage loans take out the whole global financial system? That's how. ("Can't grasp credit crisis? Join the club," David Leonhardt, NY Times, March 19, 2008.)

The problem wasn't confined to the subprime mortgage market, either. Housing prices went up so rapidly that many people, even those with good credit and decent incomes, decided that investing in it was a sure thing. Empire of Debt describes the process of flipping which was mentioned earlier—buying a house on credit and holding on to it for a little while, as its value inflated, and then selling it for a profit:

The cost of housing, in many areas of the country, was not just inflating—it was blowing up like a front-seat air bag. … Buyers were not looking for a place to live; they were speculating—betting that [they'd make] enough money to make them rich.

One genius buys a condo before it is built. He flips it to another investor, who holds it until it is completed, making a bundle when he sells it to a professional couple who intend to stay for two years and then sell (at a huge profit) to other buyers. All of them are making the smart moves—buying with little money down and making minimum monthly payments on adjustable rate mortgages. And all of them are getting richer—or so they believe—as long as prices continue to rise.

The problem, of course, was that housing prices didn't continue to rise. An AP article describes the downward spiral that resulted:

When [housing prices] began to crumble, so did financial stability.

The same people who made a financial stretch to buy their homes are now defaulting on the loans at alarming rates. Many are "upside down" on their loans, meaning they owe more on their mortgages than their homes are worth.

[Editor: For example, perhaps someone took out a $250,000 mortgage on a new house, figuring that they'd sell it when its value reached $300,000 and make a tidy profit. They could put a few thousand dollars down, get a mortgage that had low interest rates for the first year, and make a $50,000 profit in no time. But suddenly housing prices fell and no one was interested in buying their house for $300,000, or $250,000, for that matter. The value of their house had been inflated in the first place, and they're having trouble selling it for any amount of money now. But they have a $250,000 mortgage loan they owe, and suddenly interest rates are rising inexorably. Flipping has turned into floundering, and flopping.]

Nearly 9 million households now have upside-down mortgages, and for the first time ever, mortgage debt is bigger than the total value of homeowner equity [cash invested]—bigger by $836 billion, according to research by Merrill Lynch.

The housing problem set off the dominoes: Surging defaults meant the mortgage-backed securities plunged in value. Bear Stearns found itself in the cross hairs. Rumors began to swirl [as people wondered] whether it had ample reserves to cover potential losses. Clients and investors began to demand their money back.

"I think the current financial crisis looks to me like the worst one since we got into the Depression," says Richard Sylla, who teaches the history of financial institutions at New York University's Stern School of Business.

Economists and market historians seem to agree that this is more than a typical, cyclical slump. And the X-factor that sets it apart—determining how deep the wounds from the mortgage mess really are—also makes it impossible to map the path of the downturn. ("US Ponders: How Deep Is Economic Abyss?" Rachel Beck and Erin McClam, Associated Press, March 23, 2008.)

"They didn't really know…" 

The mortgages which were sold to banks, pension funds, and investors around the world were packaged in such a complex way that they practically defied understanding. As a result, many financial firms aren't even sure how much money they've lost yet—or how much the remainder of their mortgage-backed assets are worth.

Bill Bonner, writing in his Daily Reckoning newsletter, reports on his conversation with a source who is very close to the Bear Stearns situation:

"What went wrong?" we wanted to know. "How could this group of very smart accountants, lawyers, and investment pros have been so wrong about what they had in their own portfolios?"

"Well, they didn't really know. And they still don't really know," said our source. "They have no reliable way of knowing what their 'assets' are worth. They're … marked to whatever fantasy they have in their heads at the moment. When the fantasy was positive, the assets were worth something. When the fantasy turned into a nightmare, they panicked and wanted to get rid of them in the worst possible way.

"And the really scary thing is that the other financial institutions are in much the same situation. They don't really know what they have … or what it is worth. There are almost certainly some more horror stories that will be coming out." (The Daily Reckoning, March 20, 2008.)

Banks, financial firms and companies around the world are apprehensive about what will happen next, as are economists.

"It's going to go from bad to worse. … This is certainly the worst financial crisis in the last 50 or 60 years," says Kenneth Rogoff, a former chief economist at the International Monetary Fund and now an economics professor at Harvard.

Today's financial problems could likely be seen as "the most wrenching since the end of the second world war," Former Federal Reserve chairman Alan Greenspan wrote in the Financial Times (March 17, 2008).

(The follwing was received in prophecy.)

(Jesus:) The root of the problem is the same as it has been for centuries: credit, which leads to debt that spirals into ever greater debt. Then those who are lenders gamble that they can make even more money by devising new and more lucrative ways for people to go more deeply into debt, while the people themselves gamble on what they consider a sure thing, just what they need to pay off their debts, or set themselves up for retirement, or finance their lifestyles, etc.

Credit has become the drug of choice of the modern world, far more widespread than any other. Individuals, companies and governments must have their fix of it, for they are addicted to it, and the withdrawal symptoms are too painful to endure. Life without credit means no future debt is possible, and often their present debt is so large and overwhelming that they cannot go on without another credit fix.

Like many drug users, however, they do not see that they have a problem. They're surrounded by other users who are in similar situations. "Credit and debt are just the way of the world, a necessity, and nothing to worry about. Everyone does it and no one's especially concerned about it. Besides, it feels good and helps make life more enjoyable. I need it. I've got to have it."

Occasionally the "users," the debtors, feel the pain of their addiction and regret what they've gotten themselves into; but a fresh infusion of credit brings relief and temporary surcease from the pain. (End of message.)

 

END Editors