More on the U.S. Mortgage Mess

I wrote a short entry several months ago trying to get behind the U.S. mortgage mess. I thought that was a good quick primer on how we got into the situation we're in economically. I was skimming through Mankiw's blog today, though, and came across this really funny cartoon primer on the subprime mortgage problem. It's about 45 slides, but worth the time to flip through. It's a much more amusing way of looking at what happened.

So, how does the U.S. get itself out of this situation? Bernanke this past week recommended that bank's should either lower the principal amount on at-risk mortgages or that the federal government (via the Federal Housing Administration) should back-stop those loans themselves. I can only speculate, but I imagine the Fed is worried about all of those loans continuing to default and needing to be written down. If that were to happen, the losses would continue to spiral down to other parts of the economy, feeding the "deleveraging" spiral that's currently happening. The vicious cycle of "deleveraging" basically works like this:

• When credit was easy to obtain, homeowners, hedge funds, and other borrowers loaded up on debt (or "leveraged" up) so that they could gain a greater return on investment than their own money would allow them to do. (See the graphic above on how much total debt has increased over the last few years).
• That easy credit has all dried up now. That means no more "no-money-down-mortgages". It also means quicker demands for loan repayments when hedge fund investments don't work out. Not only has easy credit dried up, credit has in fact tightened further. (As an example, it's very difficult to get a jumbo mortgage in SF these days). That means, as an example, bigger down-payments and higher interest rates for home buyers than normal.

The effect on the mortgage side is that ...

• a) Tighter credit terms in effect makes homes more expensive to buy (from a buyers perspective). Those homes are then viewed as unaffordable.
• b) Home prices must then fall until they are viewed as being affordable. (We're seeing home prices fall across the U.S.).
• c) Falling prices make lenders nervous about the collateral that's backing their loans, so they tighten lending standards even further.
  

And then on the hedge fund side ...

• a) Banks start calling in loans to hedge funds (via margin calls).
• b) Those hedge funds are forced to sell off assets to raise cash to pay off the margin calls.
• c) The selloff of those assets drives prices down, leading to more losses and more margin calls.

In both cases, there's a vicious cycle that is created. And without a doubt, there would be significant instability created in the economy, which the Fed generally doesn't like. The benefit of the whole thing, though, is that the market emerges eventually much healthier than it went in. It's a correction to unsustainable investment practices. So, when I read about Bernanke's recommendation, it just didn't seem quite right to me for some reason. I couldn't wait to read the opinion page in the WSJ the next day. And, of course, there was a great opinion piece on the topic.

The thing that's obviously so unfair about the whole recommendation is that you're basically just arbitrarily shifting capital to bad debtors. And you're asking either the banking system or the taxpayers to do that. Here's a good excerpt:

Mr. Bernanke's broadside might well hamper these voluntary workouts by signaling to other borrowers that they needn't do anything at all. They can merely sit tight and wait for their banker to tell them they don't owe nearly as much as they thought. Or they'll conclude they can wait for Congress to provide its own mortgage bailout, this time on the backs of taxpayers who decided not to speculate on real estate during the housing bubble, or not to purchase a more expensive home than they could afford.

And then another good one that also speaks to the system finding a healthy new bottom to start from:

The worst irony here is that the mortgage crisis is in large part the fault of the Fed's own reckless monetary policy. Low real interest rates for too long created a subsidy for debt that spurred the housing and credit bubbles that have now burst. Prices got higher than they should have been, and the first step in any recovery is letting those now-falling prices find a new bottom. Government interference in that price discovery will only prolong the crisis, increasing the chances that the losses are eventually dumped onto taxpayers.

But then how painful would it be to find that bottom? And are we willing to live with that for the next few years? Or is it better to just forgive all those people of their poor investment decisions? I suppose that's where politics will come into play here.