Can’t Grasp Credit Crisis? Join the Club

Raise your hand if you don’t quite understand this whole financial crisis.

It has been going on for seven months now, and many people probably feel as if they should understand it. But they don’t, not really. The part about the housing crash seems simple enough. With banks whispering sweet encouragement, people bought homes they couldn’t afford, and now they are falling behind on their mortgages.

But the overwhelming majority of homeowners are doing just fine. So 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 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?

I’m here to urge you not to feel sheepish. This may not be entirely comforting, but your confusion is shared by many people who are in the middle of the crisis.

“We’re exposing parts of the capital markets that most of us had never heard of,” Ethan Harris, a top Lehman Brothers economist, said last week. Robert Rubin, the former Treasury secretary and current Citigroup executive, has said that he hadn’t heard of “liquidity puts,” an obscure kind of financial contract, until they started causing big problems for Citigroup.

I spent a good part of the last few days calling people on Wall Street and in the government to ask one question, “Can you try to explain this to me?” When they finished, I often had a highly sophisticated follow-up question: “Can you try again?”

I emerged thinking that all the uncertainty has created a panic that is partly unfounded. That said, the crisis isn’t close to ending, either. Ben Bernanke, the Federal Reserve chairman, won’t be able to wave a magic wand and make everything better, no matter how many more times he cuts rates. As Mr. Bernanke himself has suggested, the only thing that will end the crisis is the end of the housing bust.

So let’s go back to the beginning of the boom.

It really started in 1998, when large numbers of people decided that real estate, which still hadn’t recovered from the early 1990s slump, 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, centered around banks, to a global one, in which investors from almost anywhere could pool money to lend.

The new competition brought down mortgage fees and spurred some useful innovation. Why, after all, should someone who knows that she’s going to move after just a few years have no choice but to take out a 30-year fixed-rate mortgage?

As is often the case with innovations, though, there was soon too much of a good thing. Those same global investors, flush with cash from Asia’s boom or rising oil prices, 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 C.D.O.’s (a term that appeared in this newspaper only three times before 2005, but almost every week since last summer). Once bundled, different types of mortgages could be sold to different groups of investors.

Investors then goosed their returns through leverage, the oldest strategy around. 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 double-dip 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 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. Based on that idea, prices rose ever higher — so high, says Robert Barbera of ITG, an investment firm, that they were destined to fall. It was a self-defeating prophecy.

And it largely explains why the mortgage mess has had such ripple effects. 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. Last summer, many policy makers were hoping that the crisis wouldn’t spread to traditional banks, like Citibank, because they had sold off the underlying mortgages to investors. But it turned out that many banks had also sold complex insurance policies on the mortgage debt. 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 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. That’s why a hedge fund associated with the prestigious Carlyle Group collapsed last week.

“If anything goes awry, these dominos 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 — the ubiquity 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, 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 Streets fears. A recession could cause credit card loans and other forms of debt, some of which were also based on overexuberance, to start going bad as well.

Many economists, on the right and the left, now argue that the only solution is for the federal government to step in and buy some of the unwanted debt, as the Fed began doing last weekend. This is called a bailout, and there is no doubt that giving a handout to Wall Street lenders or foolish home buyers — as opposed to, say, laid-off factory workers — is deeply distasteful. At this point, though, the alternative may be worse.

Bubbles lead to busts. Busts lead to panics. And panics can lead to long, deep economic downturns, which is why the Fed has been taking unprecedented actions to restore confidence.

“You say, my goodness, how could subprime mortgage loans take out the whole global financial system?” Mr. Zandi said. “That’s how.”

Fairfax, Va.

FEAR is ruling the financial markets. Billions of dollars have been lost in mortgage-related investments. The Federal Reserve worked madly over the weekend to engineer a takeover of Bear Stearns and avert a systemic meltdown. But the big fear remains. How low will house prices go?

If prices continue to fall, mortgage defaults will move well beyond the subprime sector. Trillions of dollars in losses for investors are not impossible. But that doesn’t mean they are inevitable.

In 1997, inflation-adjusted house prices were close to their average levels over the previous half-century. Only four years later, the price of the average home nationwide exceeded anything ever seen before in the United States. Prices continued to rise for another five years, peaking in 2006 at nearly twice the average price in 1997 (as can be seen on the graph on the bottom right, which is based on data collected by the Yale economist Robert Shiller). If house prices are heading back to the levels seen in 1997, then we are facing catastrophe.

But there are good reasons to believe that much of the increase in prices was a rational response to changes in fundamental factors like interest rates and supply. The deeper fundamentals continue to suggest strong housing prices for the future.

Sure, speculation did run rampant toward the end of the housing boom. (The debut of the reality television show “Flip That House” on Discovery Home Channel, followed shortly by “Flip This House” on A&E, was a clear sign that the boom’s end was near.) Prices will fall further, especially in the speculative developments built on the outskirts of the major cities. So yes, we overshot the fundamentals.

Still, especially in coastal areas where zoning regulations have restricted the supply of land that developers can build on, house prices were driven up by increasing population, low interest rates and strong economic growth.

More and more people want to live on the coasts, but land is hard to come by in places like Manhattan and San Francisco. Cities and regions built on ideas — like Boston, Los Angeles, New York and the San Francisco Bay Area — have grown even as areas built on manufacturing, like Detroit and the Rust Belt, have declined. And of course, government isn’t getting any smaller, so Washington and its suburbs, another hot spot of rising house prices during the boom, will continue to grow.

Even in places where land seems plentiful, zoning and other land-use regulations have made it scarce. To meet demand, we should encourage high-density development, but homeowners fought to restrict housing supply when house prices were increasing. Now that house prices are falling, the incentives of owners to restrict supply are even stronger.

Several studies estimate that the average house prices of 2004 were close to fundamental levels, so we may see prices stabilize near that level.

Granted, a catastrophe is not impossible — it did happen in Japan. House prices shot up in Japan in the late 1980s, and by 1999 they had collapsed. The graph on the top right, of Japanese and American house prices, does make for a worrying comparison. (The data come from the Standard & Poor’s/Case-Shiller national home price index and a similar index for Japan.)

But the resemblance isn’t as close as the graph makes it appear. The Japanese run-up in home prices was faster and reached higher levels than the one in the United States. In addition, the Japanese population at the time wasn’t growing, and today it’s shrinking. (None of the major presidential candidates favor drastic reductions in immigration, so population growth in the United States will continue.) As a result of these and other problems, the Japanese economy was moribund from 1992 to 2002, which kept housing prices low.

There are two very real problems for the housing market: tougher credit conditions and slower growth. Here the United States faces a self-fulfilling prophecy problem.

If the financial markets can predict where and when house prices will stabilize, then credit conditions can quickly return to normal, the economy can expand and house prices will indeed stabilize.

But if the financial markets remain uncertain about when the decline in house prices will end, then fear will tighten credit even further, which would strangle the housing market and generate even more fear.

We have nothing to fear but fear itself, but fear itself can be pretty scary. The best way to overcome fear is to look at the long run. The typical homebuyer keeps a home for 10 years or more, so there is time for those who bought in 2005 and 2006 to weather the current decline in prices. Those who bought at the top are unlikely to see any windfalls from house appreciation, but they will not necessarily suffer from buyers’ remorse. Owning a home has its advantages: the deduction on mortgage interest is substantial and too much of a sacred cow to ever be repealed, and there is a certain security and satisfaction to owning your own home.

The collapse of housing prices certainly feels painful, and for some homeowners, it will be. But the houses are still there, as good as ever. Most of the gains going up were paper gains, and most of the losses going down are paper losses.

The strength of an economy comes, fundamentally, from what it can produce. Can America still produce homes? Yes. Can America still produce desirable urban and suburban areas that people are willing to pay a fortune to live in? Yes.

That’s the real bottom line. The United States has some of the most valuable real estate in the world. Markets should not forget that.

WASHINGTON — With the blessing of the Bush administration, the regulator of the nation’s two largest mortgage financing companies on Wednesday continued on its path of easing restrictions on the companies in an effort to calm financial markets and stabilize problems in the housing industry.

Regulators and administration officials said the latest move reducing the extra cushion of capital required by the two companies, Fannie Mae and Freddie Mac, would enable the mortgage giants to invest $200 billion more in mortgages.

Combined with restrictions that were eased last month that will enable the companies to help finance a greater variety of mortgages as well as much more expensive home loans, the officials predicted that the two companies would be able to buy or guarantee about $2 trillion in mortgages this year.

Created by Congress, the two publicly traded companies buy mortgages from lending institutions and then either hold them in investment portfolios or resell them as mortgage-backed securities to investors. They play a vital role in providing financing for the housing markets.

But after significant accounting problems in recent years, the companies since 2004 were required to hold 30 percent more capital than the minimum previously required, in effect capping their ability to purchase mortgages at an inopportune time.

As part of a deal with regulators, they will be able to reduce that amount by a third, to 20 percent. For Fannie Mae, that means holding $3.2 billion less capital, while for Freddie Mac it comes to $2.6 billion less.

In exchange, the mortgage finance giants have committed to raise “significant capital” in the future, though that pledge is vague. Regulators are also planning soon to lift the requirements of a settlement made with the government to resolve the enforcement proceedings against the companies.

At the end of 2007, Fannie Mae had $45 billion in capital and Freddie Mac had $37 billion, for a total of $82 billion between them. That cushion supports more than $1 trillion of combined debt.

In a statement issued after the announcement, Treasury Secretary Henry M. Paulson Jr. said the decision would make more financing available for mortgages.

“Additional capital will enable the companies to help more homeowners and will strengthen the underlying fundamentals of the mortgage market,” Mr. Paulson said

The announcement marked a stunning and, some say, risky change of course for the administration and the regulator that supervises the companies.

As recently as last fall, senior administration officials had been urging Congress to adopt tighter regulations on the companies that would limit their flexibility to hold mortgages. The concern by some officials, including the current and former chairmen of the Federal Reserve, has been the implicit guarantee of government backing in case either company defaults on its debts, which are huge.

The Bush administration has repeatedly said there is no such guarantee, but investors continue to believe _ as evidenced by their willingness to lend to Fannie and Freddie at lower rates of interest _ that the companies are “too big to fail” and that the government would mount a taxpayer bailout in case of a default.

But at least in the short term, Wednesday’s decision reduces the cushion of money that supports the companies’ borrowings _ and also stands between the companies and a possible taxpayer bailout should they encounter any major problems.

“I think it’s very dangerous and it’s a sign that people are very frightened,” said Thomas H. Stanton, an expert on the two companies. “At a time in which finance companies are holding questionable assets and facing losses, regulators typically require more capital, not less.”

Mr. Stanton and other experts said that, should the markets continue to decline, the two companies could face significant problems.

Rocked by accounting scandals, Fannie and Freddie had been under tight government regulation. The administration had maintained for years that Congress ought to curtail the companies from expanding their investment portfolios for fear that any significant trouble encountered by the companies could prompt a costly bailout. As part of the agreement, the regulator, the Office of Federal Housing Enterprise Oversight, or OFHEO, said it expected to lift an array of conditions imposed on the two companies after

At a news conference this morning, James Lockhart, the director of OFHEO, rejected the notion that the moves to reduce capital would make the companies more vulnerable.

“The actions we’re taking today makes the idea of a bailout nonsense in my mind,” Mr. Lockhart said. “The companies are safe and sound and they will continue to be safe and sound.”

But some analysts disagreed, saying there was a need for concern.

“If the markets continue to decline, Fannie and Freddie will be two of the bodies on the beach,” said Karen Shaw Petrou, managing partner of Federal Financial Analytics, a consulting company. “The argument is settled that the less capital the companies hold, the more risk they take.”

As recently as last summer, federal regulators were blocking efforts by Fannie and Freddie to expand their portfolio of mortgage holdings. And in a letter last September to Congress, Ben S. Bernanke, the Federal Reserve chairman, said that relaxing portfolio restrictions on the two companies could prove “ill advised.”

Officials said the Wednesday announcement was precipitated in part by the events from last week. In response to the credit crisis, the Federal Reserve announced that it would lend up to $200 billion to institutions and would use Fannie Mae and Freddie Mac debt and other mortgage-backed securities as collateral. The stock of the two companies, which had been declining significantly, jumped in response.

A day after the announcement, Richard F. Syron, the chairman and chief executive of Freddie, announced that it would not increase its capital because such a move could harm shareholders.

At the same time, the administration and OFHEO have come under increasing pressure from Democratic lawmakers in the House and Senate to ease restrictions on the two companies.

The announcement was applauded by Senator Charles E. Schumer, Democrat of New York, who had been urging regulators to ease restrictions on the companies.

“This is a major step forward that should help mitigate the spread of foreclosures and provide some relief to the credit markets in general,” Mr. Schumer said. “Fannie and Freddie ought to now become more involved in distressed areas of the market, like jumbo loans and subprime refinancings.”

The top executives of the two companies also hailed the decision.

“Everybody should be happy about what’s going on today,” said Richard F. Syron, chairman and chief executive of Freddie Mac. “It shows the best of the regulatory system.”

Daniel H. Mudd, the chief executive of Fannie Mae, said the decision “provides stability in a market which needs additional help.”

“Ultimately we hope it means buyers get lower mortgages and that people facing adjustable rates can refinance at affordable levels,” Mr. Mudd said.