U.S. Mortgage Crisis Rivals S&L Meltdown

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Buying Time

When the Fed began to raise interest rates in 2004, mortgage rates also began to climb. Initially, home prices kept rising as home buyers turned to mortgages with low initial payments, assuming they could sell or refinance before the mortgage rate adjusted higher. Borrowers who had trouble making payments could easily buy more time by refinancing into bigger loans, thanks to higher prices. That kept defaults low and encouraged rating agencies to continue blessing securities backed by such mortgages with high ratings.

Then, in places like Florida, buyers stopped coming. Mr. Delzio listed one home, on which he spent $203,000, at $210,000. He then cut the price repeatedly, finally to $175,000, barely more than the mortgage. He now rents it for $800 month, well short of the $1,400 monthly carrying cost.

Selling is made all the more difficult by the ample supply of homes and vacant land for sale in the area. Nationally, there were 2.1 million vacant homes for sale in the third quarter, equal to 1.6% of all the homes in the country -- a record.

At the end of 2006, the value of all homes in the U.S., excluding rentals, peaked at 153% of gross domestic product (or about $21 trillion) -- the highest level in at least six decades. By Sept. 30, that had edged down to 150% of GDP as home prices began to drop. With huge inventories of unsold homes soon to swell with foreclosed properties, that is likely to continue.

Falling home prices make consumers poorer and less ready to spend, and they make it harder to borrow against home values -- even if consumers are current on their payments.

Surrounded by Foreclosure

The downturn is particularly tough on those surrounded by foreclosed homes. Melissa Pohlman and her husband bought a renovated home in North Minneapolis's down-at-the-heels Jordan neighborhood three years ago for $205,000. It was most recently assessed by the city at $230,000. Ms. Pohlman, a 29-year-old pastor, hoped it would eventually rise to $240,000, at which point they would have enough equity to stop paying $160 a month for private mortgage insurance.

But hundreds of homes in the area are being foreclosed, and she doesn't even "want to know" what it is worth now. "You're dealing with an already transient neighborhood and then you heap on top of that a ton of foreclosures -- there are a lot of vacant homes, a lot of houses that are boarded up."

The pressure on homeowners is only part of the picture. A potentially bigger issue is the impact of this bad debt on banks and investors -- and their continued willingness to lend to consumers and businesses.

Mortgage securities typically consist of 10 or more different slices -- from highly rated slices for conservative investors all the way down to low-rated, riskier slices for investors looking for bigger returns. Each slice has its own set of rules governing when and how investors will get paid or suffer losses. Rising defaults can actually be good for some highly rated slices, which get paid off faster as a result. Many lower-rated slices, though, pay back the original investment only after three years, and only on the condition that defaults remain low. That means the value of a security issued in 2006 stands to be a big question mark until 2009.

"Maybe people will get wiped out, maybe they won't -- we won't know until two or three years from now," says Dan Castro, managing director at GSC Group, a New York-based asset-management firm that focuses on the mortgage market.

Ken Guy, finance director of King County, Wash., says the county's investment pool bought short-term IOUs called commercial paper backed by several SIVs because they appeared to be low risk. "We relied heavily on the ratings agencies," he says. About 10% of his $4.8 billion fund was invested in such paper. When the mortgage-backed assets held by the SIVs suddenly started going bad, some of his investments were downgraded all the way to "default."

"How could this have happened so quickly?" Mr. Guy wondered with colleagues. "How could these be downgraded from top to bottom in a day or two?" Such questions have been raised repeatedly.

"We've seen an unprecedented decline in market liquidity, really beyond what we thought possible," says Noel Kirnon, executive vice president in charge of structured finance at Moody's Investors Service, one of the two large ratings firms.

"Ratings on SIVs are significantly impacted by the market trends...even when the underlying portfolio maintains its credit quality," says a spokesman with Standard & Poor's, the other large ratings firm.

The complexity of mortgage-backed securities is making banks more vulnerable to losses than expected. It turns out banks didn't manage to shed so much of the risk of lending by packaging mortgage loans into securities and selling them to investors. Instead, they kept a large portion of the risk in various forms, including pieces of the CDOs they helped bring to market.

They also sometimes struck deals to provide emergency funding to SIVs and managers of CDOs -- obligations that weren't always clearly spelled out in their financial statements. Such agreements with CDO vehicles led to much of the $8 billion to $11 billion in write-downs that Citigroup Inc. says it expects to suffer in the current quarter.

With mortgage losses mounting, banks all over the world are shying away from risk. Swiss bank UBS AG recently announced four billion Swiss francs ($3.54 billion) in third-quarter losses on securities backed by U.S. mortgages and has warned of more to come in the current quarter. In one of a number of moves aimed at cutting back on risk, the chief executive, Marcel Rohner, has said he plans to slash the investment bank's assets by 30%, which means putting a lot less money into securities.

Because everyone from auto dealers to Main Street banks now depends on securities markets as a source of credit -- as opposed to banks -- such moves could make it more difficult for consumers and companies to get money.

Banks are also wary of lending to one another. They are trying to keep as much cash as possible as a cushion against potential losses, and they are worried that their counterparts could go belly up. As a result, they have been charging each other much higher interest rates. Those rates, in turn, affect monthly payments on millions of credit cards and mortgages in Europe and the U.S.

Asset prices stop falling when markets conclude that all the bad news has been factored in. At that point, so-called vulture investors pounce. But most are holding back because they think banks and SIVs could yet be forced to sell more of their holdings of subprime-backed securities into a market with few buyers.

'Littered with Corpses'

TCW Group, a Los Angeles asset-management firm, raised about $1.5 billion over the summer in anticipation of finding distressed opportunities in the mortgage market. But Jeffrey Gundlach, chief investment officer, says he has invested less than a quarter of those assets so far. "The 2007 capital markets are littered with corpses of the people who thought [subprime bonds] were a good buy at 90, 80, 70, 50, 40, 30 and 20 cents on the dollar," says Mr. Gundlach, a mortgage expert since the 1980s. He looks at 50 depressed mortgage bonds for every one he buys.

In spite of the gloom, the economy may avoid recession. Housing comprises a much smaller share of the economy than business investment, which dragged the U.S. into recession in 2001. Also, the rest of the world is stronger than in 2001, boosting U.S. exports. For the entire U.S. economy to contract would probably require a broad decline in consumer spending, which hasn't happened since 1991.

And, while financial problems are serious, they aren't -- at least yet -- on a par with those of the 1980s, when many major banks would have been insolvent had they valued their Third World loans accurately. There is, indeed, a possibility that the opacity of today's mortgage securities means markets may be factoring in far larger losses than will actually occur. Though the Fed is still worried about inflation, it has plenty of room to cushion the economy with additional interest-rate cuts.

But after years of living off the debt-financed increases in the value of their homes, U.S. consumers are in uncharted territory. "A lot of people, including me, have been saying that the country has been spending more than it's been producing, and that will have to come to an end," says Mr. Volcker. "The question is: Does it come to an end with a bang or whimper?"

--Kelly Evans contributed to this article.

Write to Greg Ip at greg.ip@wsj.com, Mark Whitehouse at mark.whitehouse@wsj.com and Aaron Lucchetti at aaron.lucchetti@wsj.com

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