Analytics, Real Estate

House prices are falling with no bottom in sight. Saddled with mortgages they can’t afford, families are defaulting on their payments and losing their homes to foreclosure. The banks holding large mortgage portfolios on their balance sheets are insolvent. The government has issued a round of recapitalizations in a bail-out to try to save the banking sector, but it’s not enough, and the country’s biggest banks are failing and being nationalized. The economy is shrinking, unemployment is rising, the stock market is shaky, meager retirement savings are wiped out, and people are afraid.

Wait: I’m talking about the US, not Latvia. This is the situation here in Arlington, Virginia.

What happened?

Punctured by the price collapse of mortgage-backed securities in the US in beginning in 2007, the worldwide asset-price bubble is rapidly deflating. From housing to stocks and bonds and even commodities like oil, prices have dropped dramatically around the globe. No Latvians, you are not alone.

Here in the US, the numbers are staggering. In late 2006 the total value of real estate in the US was approximately $23 trillion dollars. Economist’s estimate it will take two successive years of 15% price declines to deflate the housing bubble. And the deflation typically overshoots by 5%, which will leave the US property stock valued at about $16 trillion, an evaporation of $7 trillion dollars! To top it off, American investors saw an additional $7 Trillion of losses in their stock portfolios in 2008.

This was the discredited American business plan: Buy all our manufactured goods from China, and borrow back the money we pay to them. Trade our houses back and forth to each other at ever-rising prices, so we feel rich. Spend every penny we make, and save nothing, because the party will go on forever!

Well, the party ended just as the first baby-boomer retired, and decided they wanted a smaller house. The Ponzi scheme collapsed. Who was at fault here? Well there is lots of blame to go around.

Who is to blame?

Let’s start with the average American citizen, who lived irresponsibly, and voted against any politician who was brave enough to tell him so. Those politicians that did get elected established policies to extend home ownership to families that simply could not afford to own a home, and set up Fannie Mae and Freddie Mac to keep the party going. The bankers were only too happy to underwrite all these mortgages, including high-interest sub-prime loans to the least affluent buyers, collecting billions of dollars of fees along the way. Mortgage underwriting fees collected by the banks reached $50 billion in 2006. Why could the banks keep issuing these mortgages to people who couldn’t afford them? Because Wall Street financial wizards had figured out how to take mortgage portfolios, perform risk-layering and resecuritization of the mortgage bundles, and issue new securities with names like Collateralized Debt Obligations (CDOs) and insurance against losses in CDOs called Credit Default Swaps (CDSs).

The risk-rating agencies like Moody’s were paid to rate these instruments, and by magic a CDO made up of sub-prime mortgages got a AAA investment grade stamp. And these AAA CDOs could be sold to just about anyone, and they were, spurring the whole US housing bubble. The investment banks like Merrill Lynch, Lehman and Bear Stearns made hundreds of billions of dollars rolling up, issuing and selling the CDOs. And big insurance firms like AIG sold vast amounts of CDSs to cover any prospective losses. About – hold your breath – $400 trillion of these CDSs are outstanding. That’s about 8 times the whole world’s annual GDP! Wall Street executives paid themselves over $26 billion on bonuses in 2006, to celebrate their genius. Brilliant!

And who was watching over this?

You guessed it, nobody except for the cheerleaders. The Democrats in the House with oversight responsibility for Fannie Mae kept urging them to make more mortgage loans available, despite regulators and auditors shouting that their portfolios were laden with undisclosed risk. Fannie Mae paid millions in campaign contributions to these committee members, like Rep. Barney Frank and Sen. Christopher Dodd. Furthermore, the Congress had specifically forbidden the Security and Exchange Commission (SEC) from regulation hedge funds or the explosive new CDS instruments. But the SEC still failed in regulating that which was within its purview, namely the investment banks, who took on more and more leverage and riskier and riskier portfolios. The balance sheets of the financial firms SEC regulated were an utter fantasy, and the SEC cheered all the way. Meanwhile, the New York Federal Reserve had regulatory oversight over the big New York banks like Citi. Lead by Timothy Geithner, they said not a word as the debacle unfolded. Geithner’s punishment: President Obama just made him Secretary of the Treasury, despite the fact he was exposed as a tax cheat, and will now oversee the tax collecting agency the Internal Revenue Service. Oh, there is plenty of blame to go around. We should fill Sing Sing prison with these white-collar criminals, the politicians, the regulators, the bankers, the ratings agencies, and on and on.

If you haven’t figured it out yet, the Wall Street wizards figured out how to make a financial nuclear bomb powerful enough to blow up the whole world’s economy. What happened? KABOOM!

What is to be done?

So what is to be done? Well the cure for this applies equally to the US or Latvia or Japan for that matter. Here is the seven-step national economic recovery plan that is needed now:

1) Stabilize the banks and financial institutions. Force a full clean-up and write down of all bad loans. Seize all insolvent financial institutions, recapitalize them or liquidate them, and sell back the viable ones to the public in and orderly fashion, just like was done in the savings and loan crisis by Resolution Trust Corp.

2) Provide relief to mortgage holders by providing a 4% fixed term mortgage to homeowners and new buyers who can afford to pay their debts.

3) Overhaul the banking, financial sector and securities laws and regulatory structure so that there is a clear line of regulatory responsibility for each institution and financial asset class. For goodness sakes, regulate the Credit Default Swaps, other derivatives and the hedge funds. Improve the transparency of financial firm’s balance sheets. Regulate the scandalous mortgage underwriting industry, preventing the issuance of unviable or immoral mortgages.

4) Provide protection from the worst of the economic downturn to the most needy, the elderly, the sick, the disabled and the indigent, with temporary social benefits programs. Increase the direct monthly payments to mothers with infant children, to encourage fecundity while providing an economic stimulus.

5) Provide temporary tax breaks for companies that create jobs.

6) Establish a commission to investigate the fiasco, to identify the guilty in every sector public and private, and prosecute them to the fullest extent of the law, in a timely and transparent manner. Claw back ill-gotten gains.

7) Announce the plan, act quickly and stick to it firmly, because the foremost thing that is needed is stability. Investors and citizens alike detest uncertainty.

 Edward Jurkevics is Principal Analyst with Chesapeake Analytics of Arlington, Virginia. He can be reached at [email protected].