November 24, 2007 in Business

Mortgage failures could be economic nightmare

Joe Bel Bruno Associated Press
 

NEW YORK – When Domenico Colombo saw that his monthly mortgage payment was about to balloon by 30 percent, he had a clear picture of how bad it could get.

His payment was scheduled to surge by an extra $1,500 in December. With his daughter headed to college next fall and tuition to be paid, he feared ending up like so many neighbors in Ft. Lauderdale, Fla., who defaulted on their mortgages and whose homes are now in foreclosure and sporting “For Sale” signs.

Colombo did manage to renegotiate a new fixed interest rate loan with his bank, and now believes he’ll be OK – but the future is less certain for the rest of us.

In the months ahead, millions of other adjustable-rate mortgages like Colombo’s will reset, giving them a higher interest rate as required by the loan agreements and leaving many homeowners unable to make their payments. Soaring mortgage default rates this year already have shaken major financial institutions and the fallout from more of them, some experts say, could spread from those already battered banks into the general economy.

The worst-case scenario is anyone’s guess, but some believe it could become very bad.

“We haven’t faced a downturn like this since the Depression,” said Bill Gross, chief investment officer of PIMCO, the world’s biggest bond fund. He’s not suggesting anything like those terrible times – but, as an expert on the global credit crisis, he speaks with authority.

“Its effect on consumption, its effect on future lending attitudes, could bring us close to the zero line in terms of economic growth,” he said. “It does keep me up at night.”

Some 2 million homeowners hold $600 billion of subprime adjustable-rate mortgage loans, known as ARMs, that are due to reset at higher amounts during the next eight months. Not all these mortgages are in trouble, but homeowners who default or fall behind on payments could cause an economic shock of a type never seen before.

Spiraling effect

Some of the nation’s leading economic minds lay out a scenario that is frightening. Not only would the next wave of the mortgage crisis force people out of their homes, it might also spiral throughout the economy.

The already severe housing slump hitting many parts of the country would be exacerbated by even more empty homes on the market, causing prices to plunge by up to 40 percent in once-hot real estate spots such as California, Nevada and Florida. Builders could go under. Global banks, which repackage loans into exotic securities such as collateralized debt obligations could suffer far greater write-offs than the $75 billion already taken this year.

Massive job losses would curtail consumer spending that makes up two-thirds of the economy. The Labor Department estimates almost 100,000 financial services jobs related to credit and lending in the U.S. have already been lost, from local bank loan officers to traders dealing in mortgage-backed securities. There’s no telling how that would affect car dealers, retailers and others dependent on consumer paychecks.

Based on historical models, zero growth in the U.S. gross domestic product would take the current unemployment rate to 6.4 percent. That would wipe out about 3 million jobs from the economy, according to the Washington-based Economic Policy Institute.

By comparison, in the last big downturn between 2001-03 some 2 million jobs were lost, according to the Labor Department. Many Americans are unaware that a borrower defaulting on a loan can have an impact on everyone else’s well-being and that of the nation. After all, the amount of mortgages due to reset is just a fraction of the United States’ $14 trillion economy.

But the series of plunges that Wall Street has suffered in past months prove that no one is immune when mortgages turn sour.

Interconnected system

Today’s financial system is interconnected: Mortgages are sold to investment firms, which then slice them up and package them as securities based on risk. Then hedge and pension funds buy up such investments.

When home prices kept rising, these were lucrative assets to own. But the ongoing collapse in housing prices has set off a chain reaction: Lenders are tightening their standards, borrowers are having a harder time refinancing loans and the securities that underpin them are in jeopardy.

This has resulted in more than $500 billion of potentially worthless paper on the balance sheets of the biggest global banks – losses that could spill into the huge pension and mutual funds that also invest in these securities and that the average worker or investor expects to depend on.

Not over yet

There’s more pain left for Wall Street: “We’re nowhere close to the end of the collapse,” said Mark Patterson, chairman and co-founder of MatlinPatterson Global Advisors, a hedge fund that specializes in distressed funds.

“I just assumed banks could stomach these kind of losses,” said advertising executive Wendy Talbot, when asked about the subprime crisis. “I guess you don’t really pay attention to things until you’re forced to. … You put out of your mind the worst things that can happen.”

Sen. Charles Schumer, D-N.Y., a key member of Senate finance and banking committees, said borrowers are the ones who need relief. The playbook to bail out the economy would not be applied to the banks and mortgage originators, but money could be funneled through nonprofit organizations to homeowners that need help, he said.

“There is a worst-case scenario because housing is the linchpin of our economy, and more foreclosures make prices go down, that creates more foreclosures, and creates a vicious cycle,” Schumer said.

“You add that to the other weakness in the economy – on one end is the home sector and the other is the financial sector – and it could create a real problem.”

© Copyright 2007 Associated Press. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.


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