Is the collapse of a house of cards built on financial stupidity going to dent the U.S. economy?
The nation’s mortgage-lending industry is in such bad shape that tremors are shaking Wall Street. A record number of mortgages were foreclosed in the first quarter of this year.
Some of the nation’s biggest mortgage lenders have gone belly up, including one whose bankruptcy Monday wiped out $1.4 billion in assets. Two mortgage- related hedge funds at the big Wall Street securities firm Bear Stearns failed, causing investors to lose $1 billion.
Analysts and investors worry that the mortgage crisis will spread to the larger economy, tipping the nation into recession. Presidents and presidential candidates have taken notice.
What caused this mess? A variety factors were at work, including the record-low interest rates the Federal Reserve used to forestall a recession after the tech-stock bust in 2000-2001. The low rates made investors large and small hungry for higher returns – and more willing to make risky bets.
But more than anything else, the current crisis can be attributed to the essential foolishness of lending money to people who aren’t likely to pay it back.
A booming market in so-called “subprime” mortgages has collapsed. Subprime loans are those made to customers whose credit is too poor to qualify for traditional loans.
The amount of subprime loans rose from $160 billion in 2001 to more than $600 billion in both 2005 and 2006. Some lenders even issued “no-doc” loans, requiring no documentation of income at all.
It doesn’t take a Ph.D. in economics to recognize that lending money to someone with bad credit is risky. But if the lender can bundle subprime loans and sell them to securities firms that sell them to investors, everything’s peachy.
Lenders are happy to keep on making high-risk loans – because investors, not the lenders, are stuck with the risk. That’s the magic of “securitization.”
The easy-credit lending spree helped fuel a boom in the housing industry that rippled through the rest of the economy. Now the easy-credit days are over, as the rest of the market sees the danger.
If we’re lucky, both Wall Street and the economy will weather the mortgage crisis with minimal damage. It’s too soon to say. In any case, regulators and lawmakers need to address the lack of regulatory supervision in the non-bank mortgage industry. Some lenders – and borrowers – need to be protected from themselves.