Financial crisis the worst since 1930s?

The U.S. housing market is hurting, as you undoubtedly know. Home foreclosures are the highest since record-keeping began 35 years ago. 1.69 percent of all outstanding mortgage loans have entered the foreclosure process. The median price of an American house in October 2007 has fallen more than $20,000 this year.

This is the unpleasant aftermath of the housing bubble of the early 2000s. After the stock market bubble burst in 2000 and further weakness caused by 9/11, official Washington’s fear of a 1930s-style deflation prompted the Federal Reserve to flood the markets with cheap credit.

It should be noted in passing that the stock market boom-bust cycle that ended in 2000 was caused by the Fed’s inflationary expansion of money and credit, so it should not inspire our confidence that the Fed’s remedy for its own inflationary policies was more inflationary policies.

The artificially low interest rates engineered by the Fed — abetted by a compliant financial industry that cranked out reams of irresistible mortgages (e.g., no money down, no- or low-documentation, minuscule introductory interest rates on adjustable rate mortgages — ARMS) — had their desired effect: they stimulated a housing boom that spearheaded an economic recovery.

Unfortunately, the housing boom had undesirable consequences, too. The artificially low cost of borrowing brought buyers out of the proverbial woodwork. The resulting demand pushed housing prices higher. In addition, the low interest rates were quickly capitalized into higher asking prices for houses.

Buyers, conditioned by a decades-long trend of rising home prices, figured that as long as they could “tote the note” (that is, afford the monthly payments) then they didn’t have to worry about the actual price of the house, because they assumed that there would always be someone willing to pay an even higher price for their house.

This is the “greater fool” theory that recurs in every financial bubble.

The rise in housing prices was accelerated by enterprising individuals, called “flippers,” who bought houses, then resold them within months for thousands of dollars more.

When the history of this boom-bust cycle in housing is written, apologists for government intervention may use the flippers as scapegoats, much as earlier generations of scoundrels blamed private speculators for the stock market crash of 1929.

Why should the flippers (some of whom undoubtedly have been burned by the recent downturn) be blamed for trying to take advantage of low interest rates and easy mortgage terms when it was the Federal Reserve and their accomplices in the financial industry who created those conditions?

The Fed-induced boom resulted in house prices rising by 10 percent, 20 percent, 30 percent per year in many regions — far faster than Americans’ income was rising.

Obviously, such an imbalance was unsustainable. In less than five years, the median price of an American home increased from 2.8 times to four times the median family income.

When interest rates, hence the cost of borrowing, started to rise, demand for homes slowed. Concurrently, defaults — many triggered when ARMs reset to higher rates — rose, increasing the supply of houses on the market.

When supply exceeded demand (at different times in different communities), housing prices began to fall, and the boom turned to bust. The trend has accelerated recently.

With record inventories of unsold houses on the market today, the end of this trend is not in sight. In fact, many homeowners now find themselves with negative equity — that is, they owe more on their mortgage loan than their house is worth. Many of these loans will be defaulted upon.

Other borrowers can’t afford the higher monthly payments that are starting to become due under the terms of their ARMs.

Both of these factors will cause more foreclosures. Consequently, the glut of unsold homes will increase, thereby exerting even more downward pressure on prices in a vicious, potentially self-reinforcing downward spiral.

To break out of this grim spiral, President Bush and Democratic presidential candidates are trying to outdo each other with legislative proposals. One tack is to go after “predatory lenders.”

Undoubtedly some unscrupulous lenders cared more about earning fees than ascertaining what borrowers could afford, and misled them.

At the same time, as many as half of those who obtained no- or low-documentation loans appear to have lied about their income.

And Uncle Sam is partly to blame, too, since it is the law of the land that lending institutions cannot deny credit to poorer Americans. Clearly, though, the mortgage industry needs to resume fulfilling its primary fiduciary responsibility, which is to assess and control risk.

Another legislative proposal is to bail out borrowers in danger of defaulting on their ARMs. This suggestion has elicited angry reactions and raised profound issues of equity.

Why should those in danger of defaulting receive aid, but not those who have already defaulted?

Why should those who borrowed more than they could afford be subsidized by money taxed from responsible individuals who curbed their other spending so that they could honor their mortgages?

How can ordering lenders to freeze ARM rates be fair to those who opted for fixed-rate mortgages to avoid the risk of their interest rate being adjusted upward?

Meanwhile, our friends at the one-trick-pony Fed are giving us all a case of deja vu. Once again they are lowering interest rates and “injecting liquidity” (Fedspeak for “pumping money”) into the financial markets to reflate the economy.

It turns out that the housing bust isn’t the biggest economic threat we are facing.

There are those who say that the housing market is just one segment of our overall economy and bad loans are just a fraction of the housing market, so there is nothing to worry about.

This viewpoint is wrong, because the housing market is not sealed off from the rest of the economy.

On the contrary, clever Wall Street financiers have managed to convert a serious housing bust into a potentially cataclysmic financial crisis.

Here is what happened: The financial whiz-kids generated handsome commissions and fees for themselves through a technique known as “securitization” — the creation of financial instruments comprised of bundles of mortgages.

These pseudo-securities were then bought by hedge funds and other financial institutions that used them as security for issuing reams of exotic financial derivatives — a dizzying array of CDOs, SIVs, CLOs, CDSs, CSOs, ABCP, etc., etc. — that were then used as collateral for the creation of additional layers of CDOs, etc.

Picture a multi-story edifice of financial instruments with the securitized mortgages as the foundation.

How big is this structure of financial instruments? According to a recent report by the Bank of International Settlements, the total nominal value of financial derivatives in the world is approaching $700 trillion.

Yes, TRILLION!

Five major banks alone — Bank of American, Citibank, HSBC, JPMorgan Chase, and Wachovia — hold over $130 trillion of derivatives. That amount is 10 times our national GDP.

The banks assure us that risk is under control. That is exactly what the Nobel laureates behind Long Term Capital Management said in 1998, just before LTCM imploded and almost caused a meltdown of our entire financial system.

If a multi-trillion-dollar chain reaction of derivative failures were to occur today, pondering the aftermath boggles the mind.

And how stable is the foundation of this structure? Not very. High-risk debt — which is what many of these securitized bundles of mortgages are turning out to be — is not the kind of rock-solid asset on which to base a pyramid of derivative assets.

To cite one specific example of the shakiness of these securitized mortgages: One mortgage-based security packaged and sold by Goldman Sachs consisted of 8,274 second mortgages, 58 percent of which were no- or low-documentation, with an average equity of only .71 percent.

One-sixth of those mortgages were in default within months, rendering this security and any derivatives based on it essentially worthless.

Under new regulatory standards that became mandatory for financial institutions in November, mortgage-based securities are generally classified as Level Three (the weakest level) — meaning that there is no reliable way to price these instruments, hence, no bid, no aftermarket for them.

When one considers that such pillars of U.S. finance as Goldman Sachs, Bear Stearns, Lehman Brothers and Morgan Stanley have more level three assets than they do capital (Morgan Stanley is the most exposed, with two-and-one-half times as much level three assets as capital), you can begin to sense how precarious our financial situation is.

The financial system of our country may be collapsing before our eyes.

How many times this year have you read about major financial institutions writing down billions of dollars of bad debt?

Were you aware that several hundred billion dollars’ worth of asset-backed commercial paper has vaporized since August?

These could be the early temblors of a catastrophic financial earthquake. That is why the president and the Fed are acting so desperately.

When the president proposes stemming the tide of mortgage defaults, he isn’t worried about rewarding reckless behavior or being fair; he’s trying to prevent a financial collapse by shoring up the shaky foundation — the mortgage-backed securities — of our financial house of cards.

When the Fed repeatedly pumps tens of billions of dollars into the financial system, it is trying to patch up the crumbling foundation and superstructure of that rickety financial edifice.

The Fed would rather inflate like mad than see the financial system of our country freeze up and collapse.

Wall Street is the villain in this ongoing drama. It pains me to say that, because I believe that our capitalist system requires strong, innovative, free financial institutions. But as strongly as I believe in freedom and free markets, I also know that freedom cannot be unlimited.

Just as the right to free speech doesn’t give one the right to shout “Fire!” in a crowded theater, similarly, the right of private individuals and companies to devise innovative ways to increase profits does not justify their jeopardizing the entire financial and economic well-being of our country.

Yet, this is what Wall Street has done by recklessly creating trillions of dollars of derivatives based on the toxic, unsound foundation of mortgage-backed securities.

I don’t know if Wall Street is capable of dismantling the structure of derivatives voluntarily before it either collapses or the politicians jump in to an even bigger mess of things, but I hope it can.

Some optimists believe that the worst of the combined housing-financial crisis is behind us. I fervently hope that they are right, but it looks to me like we are still in its early stages.

Ladies and gentlemen, fasten your seat belts.

[Dr. Mark W. Hendrickson is a faculty member, economist, and contributing scholar with the Center for Vision and Values at Grove City (Penn.) College.]