Subprime Meltdown Snares Even Borrowers With Better Credit

Subprime Meltdown Snares Borrowers With Better Credit (Update3)

By Jody Shenn

March 22 (Bloomberg) -- The subprime credit crunch is beginning to ensnare even borrowers with better credit.

Lenders are increasingly refusing to lend to homebuyers who can't make a down payment of more than 5 percent, especially if they won't document their income. Until recently such borrowers qualified for so-called Alt A mortgages, which rank between prime and subprime in terms of risk. Last year the category accounted for about 20 percent of the $3 trillion of U.S. mortgages, about the same as subprime loans, according to Credit Suisse Group.

``It's going to be very difficult, if not impossible, to do a no-money-down loan at any credit score,'' said Alex Gemici, president of Parsippany, New Jersey-based mortgage bank Montgomery Mortgage Capital Corp. Companies that buy the loans ``are all saying if they haven't eliminated them yet, they'll eliminate them shortly.''

Tighter lending standards may slash subprime mortgage sales in half this year and Alt A mortgages by a quarter, according to Ivy Zelman, a Credit Suisse analyst in New York who covers homebuilders. The new requirements will force some prospective homebuyers to save more money for a down payment or risk being denied credit.

Pulling Back

Bear Stearns Cos., General Electric Co.'s WMC Mortgage, Countrywide Financial Corp., IndyMac Bancorp Inc., Goldman Sachs Group Inc., Lehman Brothers Holdings Inc. and Credit Suisse have all said in the last two weeks they're pulling back from buying Alt A mortgages sold with no down payment or in a refinancing of the house's entire value. Such companies facilitate the mortgage market by buying loans and repackaging them for sale as bonds to buyers such as insurers and hedge funds.

``We've been warned,'' said Cheryl Hand, manager of Prudential New Jersey Properties' office in Manalapan, New Jersey. She said she's hoping a client of her realty brokerage who's been approved to buy a home with nothing down won't have the loan quashed before the closing.

Mortgages are categorized as Alt A when they fall just short of the typical standards of Fannie Mae and Freddie Mac, the two largest U.S. mortgage companies. Some mortgage lenders require a credit score of at least 700 for an Alt A mortgage, while others will accept a score as low as 620. The maximum score is 850. The average credit score is in the 600s, according to Bankrate.com.

Besides some loans requiring no down payment or proof of income, they are often made to buy a second home, a rental unit or to speculate on real estate. Also often falling into the category are loans that are ``option'' adjustable-rate mortgages, whose minimum payments can fail to cover the interest owed.

Defaults Rising

Consumers borrowed 100 percent of their home's value on about 18 percent of Alt A loans made last year, according to Bear Stearns, the largest mortgage-bond underwriter. Another 16 percent had loan-to-value ratios above 90 percent as well as limited documentation, they say. The category comprised about 5 percent of new loans in 2002, according to Credit Suisse.

Late payments of at least 60 days and defaults on Alt A mortgages have risen about as fast as on subprime ones, to about 2.4 percent, according to bond analysts at UBS AG. Loans in the category made to borrowers with low credit scores, equity and documentation are doing about as badly as subprime loans, according to Citigroup Inc. and Bear Stearns analysts.

Rapid credit tightening that's ``been isolated to the subprime world has really migrated'' in the past two weeks to Alt A offerings that involve borrowing nearly all of a home's worth, said Brian Simon, senior vice president at Mount Laurel, New Jersey-based mortgage bank Freedom Mortgage Corp. ``We're just hopeful it will settle down soon.''

California Prices

A borrower would have to come up with $23,750 to make a 5 percent down payment on a typical home in California, based on a $472,000 median price estimated by DataQuick Information Systems in La Jolla, California. She'd have to show enough income to pay $2,730.87 a month with a 30-year fixed-rate mortgage at 6.15 percent.

``It doesn't help somebody to get into a home when they can't afford to make the payments and continue living there,'' said Ann McGinley, owner of Action Mortgage, a brokerage in Santa Rosa, California, that's turned away a ``few buyers'' with good credit who may have been able to get loans last year.

While loans issued only on the basis of the borrower's ``stated'' income can be abused, they're appropriate for a divorcee with alimony who ``doesn't want to show an underwriter her paperwork because it's private'' or a borrower with a reliable roommate, she said. ``I personally have made a couple of real estate agents angry by advising people to not buy.''

Limits Welcomed

Some lenders say it's high time that buyers are discouraged from buying real estate with no money down.

``Could we have a little skin in the game from the borrower, please,'' said Rick Soukoulis, chief executive officer at LoanCity, a San Jose, California-based lender that stopped making mortgages last week to customers who want to borrow more than 95 percent of the value of their house due to the shrinking secondary market. ``Something to lose if you go into default?''

LoanCity, which made about $6 billion in mortgages last year, went out of business on March 20.

The slump in subprime loans has ``drastically eroded'' appetite for bonds backed by Alt A loans, according to a March 9 report by Credit Suisse. The extra yield that investors typically demand on the parts of the securitizations with the lowest investment-grade ratings have risen to 3.50 percentage points over the one-month London interbank offered rate from 2.15 percentage points in September, according to Bear Stearns.

Resale Woes

``If you couldn't sell something, you wouldn't do it either,'' UBS analyst David Liu in New York said. Part of the problem is falling demand for ``piggyback'' home-equity loans used to make down payments, he said.

New York-based Citigroup will no longer buy home-equity loans made to borrowers who won't prove their incomes and want more than 95 percent of their home's value, according to e-mails from salespeople. Mark Rogers, a spokesman, declined to comment.

New York-based Bear Stearns, the third-largest Alt A lender according to newsletter National Mortgage News, last week stopped buying such loans without down payments of at least 5 percent. For borrowers not fully documenting incomes or assets, the maximum loan-to-value ratio will be 90 percent.

Short Notice

Bear Stearns' EMC Mortgage unit told loan sellers of the changes on March 13, giving them a day's notice. On Feb. 26, EMC said it would start requiring down payments of only 5 percent in the low-documentation category, giving sellers until March 12 to submit loans under the old standards. On March 1, the deadline moved to March 6. EMC didn't change ``full documentation'' programs then.

People with poor or limited credit records or high debt burdens can take out only subprime mortgages, and typically pay rates at least two or three percentage points above prime loans. Subprime lenders have been increasingly raising their standards since mid-2006, and started cutting out nothing-down lending in late January, Montgomery's Gemici said. People who qualify for prime mortgages don't experience any trouble getting a loan.

The subprime meltdown might have been prevented if the Federal Reserve had acted faster, a Fed official said today.

``Given what we know now, yes, we could have done more sooner,'' Roger Cole, the Fed's director of banking supervision and regulation, told the Senate Banking Committee in Washington.

Going Forward

Bear Stearns will finance 25 percent to 30 percent fewer non-prime mortgages this year as it tightens credit, Chief Financial Officer Sam Molinaro said on the company's earnings call last week.

``Last year, we did about 50 percent less in subprime than we did the year before,'' Mary Haggerty, co-head of Bear Stearns' mortgage finance department, said in an interview, adding that it has been tightening Alt A standards since December. ``We always try to be ahead of the market.''

Countrywide Financial, the nation's top home lender, this month stopped making any loans with down payments of less than 5 percent when borrowers are ``stating'' both income and assets.

Since they have good credit, most borrowers able to take out loans with little down and high monthly payments relative to their pay or potentially rising ones knew the risks, Countrywide Financial CEO Angelo Mozilo said in an interview.

``People are adults and made choices in their lives because they wanted to own a home of their own,'' Mozilo said. ``America's great because people can make those decisions for themselves. The complaints about the loans only came when the opportunity for enrichment was gone'' because home prices flattened out.

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net .

Last Updated: March 22, 2007 15:55 EDT

Fed Accused of Encouraging Subprime Loans: 'Perfect Storm’

Fed accused of subprime ‘perfect storm’

By Eoin Callan, Edward Luce and Krishna Guha in Washington

Published: March 22 2007 18:50 | Last updated: March 23 2007 00:33

The Federal Reserve helped create a “perfect storm” in the US subprime mortgage market that could expose up to 2.2m more Americans to the threat of home foreclosure, Chris Dodd, chairman of the Senate Banking committee, said on Thursday.

Mr Dodd, who is also a Democratic Party candidate for the 2008 presidential nomination, alleged the Fed had failed in its oversight role when the growth in high-risk “adjustable rate mortgages (ARM)” to risky borrowers was exploding.

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While questioning leading mortgage lenders and federal banking regulators, Mr Dodd also promised legislation to crack down on predatory lending in the US mortgage market, where a rising level of repayment delinquency has caused global market jitters during the past month.

Mr Dodd said that US regulators had relaxed guidelines on mortgage lending at precisely the point in 2004 and 2005 when the riskiest ARM loans – which impose initially light monthly payments that escalate quickly at a later date – were increasing most rapidly. That also coincided with the start of the Fed’s consecutive 17-stage rise in rates.

“Despite those warning signals the leadership of the Federal Reserve seemed to encourage the development and use of ARMs that, today, are defaulting and going into foreclosure at record rates,” he said.

Mr Dodd, who was supported by Richard Shelby, the senior Republican on the committee, also expressed frustration at the fact the Fed had so far failed to issue promised guidance to tighten controls on the $1,200bn subprime mortgage market.

An estimated 1m subprime borrowers will have their rates adjusted sharply upwards this year and another 800,000 next. Roger Cole, a senior Fed official, said the guidance would come out by May at the earliest. But he conceded that the Fed could have done more.

Thursday’s hearing could mark the start of a backlash against leading subprime mortgage lenders. Senior executives from four of the leading lenders – HSBC, Countrywide, WMC Mortgage, First Franklin – testified. Of those invited, only New Century, the largest subprime lender, declined to send a witness.

Mr Dodd said the lenders had engaged in “unconscionable and deceptive” practices. But he also admitted that it would be hard to pass a stricter law.

The Center for Responsive Politics, a watchdog, said New Century more than doubled its Washington lobbying efforts between 2004 and 2005 and contributed $342,000 in campaign funds to candidates in last year’s mid-term congressional elections.

Mr Dodd said lenders had engaged in “unconscionable and deceptive” practices.

Copyright The Financial Times Limited 2007

The Coming Mortgage Metldown

Mar 23, 2007

By Bonddad
bonddad@prodigy.net

The housing market led to the massive increase in subprime loans over the last three or so years. Underwriting standards were continually relaxed until only a pulse was required to get a loan. Now the proverbial chickens have come home to roost. 44 lenders have now either closed their doors, declared bankruptcy or sold off their assets. And in all probability it will get much worse.

The excerpts are from a WSJ (sub. required) editorial titled Mortgage Meltdown.

The primary argument advanced by housing bulls right now is the damage of subprime mortgages will be contained. However, consider these numbers:

Far from being limited to the subprime market, the data show these risky loan features have become widespread. According to Credit Suisse, the number of no or low documentation loans -- so-called "liar loans" -- has increased to 49% last year from 18% of purchase loans in 2001, a nearly three-fold increase. The investment bank also found that borrowers put up less than a 5% down payment in 46% of all home purchases last year. Inside Mortgage Finance estimates that nontraditional mortgages -- mostly interest-only and pay-option ARMs that allow the borrower to defer paying back principal or even increase the loan balance each month -- which barely existed five years ago, grew to close to a third of all mortgages last year.

The Alt-A market, a middle ground between subprime and prime, has increased seven-fold since 2001 and accounted for 20% of home-purchase loans last year. Fully 81% of Alt-A loans last year were no or low documentation loans, according to First American Loan Performance. Why have borrowers employed this kind of risky financing? Because it was the only way many of them could afford a home in some of the hottest housing markets, where prices more than doubled in five years.

Let's break these numbers down.

According to Credit Suisse, the number of no or low documentation loans -- so-called "liar loans" -- has increased to 49% last year from 18% of purchase loans in 2001, a nearly three-fold increase

This is a poorly written sentence. I am assuming he means that nearly half of all subprime loans were "liar loans". This would make sense as credit standards have continually deteriorated over the last few years.

borrowers put up less than a 5% down payment in 46% of all home purchases last year.

This has a few very negative implications.

1.) Americans aren't saving. Period.

2.) There is little home equity, which would help to cushion the effects of dropping prices. This prevents homeowners from refinancing mortgages.

3.) Lending standards have really deteriorated.

Nontraditional mortgages .. increased to a third of all mortgages last year.

That means there are a ton of highly questionable loans on the market. This is probably one reason why the number of delinquencies has increased so dramatically over the last year.

The Alt-A market, a middle ground between subprime and prime, has increased seven-fold since 2001 and accounted for 20% of home-purchase loans last year. Fully 81% of Alt-A loans last year were no or low documentation loans,

An overwhelming majority of the middle tier of mortgage risk has no documentation. That means for practical purposes, these are subprime loans.

Here's where the real problem is going to come in.

It's not the size of foreclosure losses as a share of the economy that matters, it is the effect those losses have on the availability of credit. When banks (and investors in mortgage-backed securities) begin suffering losses, they inevitably pull back. This is why so many subprime companies have gone bankrupt virtually overnight; investors balked at buying subprime loans except at a steep discount, which produced immediate losses. In effect, their ability to profitably finance new loans was eliminated.

What's more, the bank regulators are only now beginning to tighten lending standards and will be under increasing pressure from Congress to do more. After growing by nearly 50% in the first half of 2006, nontraditional loan growth has turned negative since the bank regulators issued new guidelines last September. The CFO of Countrywide recently told an investor conference that 60% of the subprime loans the company is making won't meet proposed federal rules likely to take effect during the summer. The concern that tighter lending standards could reduce access to financing is the reason a widely watched survey of homebuilders conducted by the National Association of Homebuilders dropped earlier this week.

First, Countrywide is one of the largest mortgage lenders in the country. And over half of the loans they are currently making won't be made when new lending standards take effect. That means there will be a severe credit contraction, which is never a good thing.

The ride is going to get bumpier.

For economic analysis and commentary, go to the Bonddad Blog

US housing, mortgage woes contagion feared

ANALYSIS

By Joanne Morrison, Reuters | March 22, 2007

WASHINGTON --For months as the U.S. housing market unraveled, the Bush administration, the Federal Reserve, and most economists maintained the decline did not risk hitting the economy at large, but economists are growing increasingly concerned the broad economy may take a hit.

An abrupt exodus of more than two dozen so-called subprime lenders from the market has heightened fears other lenders may soon start choking off credit to businesses and consumers.

Economists, and the Bush administration, agree falling house prices and rising defaults by borrowers with poor credit in the subprime mortgage market may mean slower U.S. economic growth this year.

"We know that the housing market will have an impact on GDP over the next six months," Edward Lazear, chairman of the White House Council of Economic Advisers, said this week.

When asked how subprime mortgage market troubles would weigh on the economy, Lazear said the banking sector was still strong, but delinquencies are high and lenders, even outside of the subprime market, have begun to tighten up credit.

"It's clearly going to increase the cost of capital and on the margin its going to be less conducive of capital spending," said Richard DeKaser, chief economist at National City Corp. in Cleveland.

According to the Mortgage Bankers Association's most recent data, the proportion of mortgages in the initial stages of foreclosure during the fourth quarter of last year hit its highest in the 37-year history of the association's survey.

In addition, commercial banks have tightened their lending standards. According to the Federal Reserve's most recent Senior Loan Officers Survey released last month, which covered lending business at the end of last year, domestic banks reported tightening standards on all residential mortgages, the highest net fraction seen since the early 1990s.

"The extent of the tightening of credit conditions for borrowers has yet to be fully clarified, and bears continual monitoring," Citigroup economist Steven Wieting wrote in a report this week.

About 45 percent of bank loan officers in the Fed survey said they expect a deterioration in the quality of the loans they make, ranging from loans for business investment to commercial real estate loans.

--MORE--

Countrywide sees record foreclosures

The Associated Press March 22, 2007, 4:47PM EST

WASHINGTON

A top executive at Countrywide Financial Corp. said Thursday that dropping home prices could produce record-high levels of foreclosures on loans made in 2006 to people with poor credit histories.

Sandy Samuels, executive managing director and chief legal officer of the Calabasas, Calif.-based mortgage lender, said in prepared remarks to the Senate Banking Committee that foreclosure rates on high-risk, or subprime, mortgages taken out last year may approach or exceed the level for similar loans taken out in 2000, when the foreclosure rate was nearly 10 percent.

However, Samuels urged Congress not to "lose sight of the reality that more than 90 percent of Countrywide's subprime borrowers will not lose their homes to foreclosure."

Samuels also warned lawmakers not to create overly tight restrictions on high-risk mortgages, saying that could lock out many would-be homebuyers.

Over the past 10 years, Countrywide's overall foreclosure rate for adjustable rate subprime loans was 3.4 percent, Samuels said. The so-called subprime mortgage market represents 7 percent of Countrywide's home loan volume, compared with 20 percent of the overall U.S. market, he said.

Samuels' testimony came as federal regulators said they lacked authority over expanding areas of the high-risk mortgage market, and as lawmakers pressed them on whether they were lax and helped fuel the spike in delinquent payments and foreclosures.

Anxiety that a blowup among subprime mortgage lenders could spill over into the broader economy has roiled the financial markets in recent weeks. New Century Financial Corp., the nation's second-largest subprime mortgage lender, has scrambled to stay afloat as banks cut off funding because of a failure to make payments.

Earlier this week, Fremont General Corp. said it would sell $4 billion in subprime residential real estate loans at a loss. And last Friday, Accredited Home Lenders Holding Co. announced plans to sell $2.7 billion of loans at a discount to satisfy margin calls from its lenders and stave off a liquidity crisis caused by rising defaults.

Sen. Christopher Dodd, D-Conn., the banking committee's chairman, laid out what he called a "chronology of regulatory neglect" as banks and other lenders loosened their standards for making riskier mortgage loans during the housing market boom in late 2003 and early 2004.

Dodd blamed the Federal Reserve and other regulators for setting off the crisis in subprime loans, which are higher-priced home loans for people with tarnished credit or low incomes who are considered at greater risk of default. Now, some 2.2 million homeowners could lose their homes in the next few years, said Dodd, a contender for the Democratic presidential nomination in 2008.

"Our nation's financial regulators were supposed to be the cops on the beat, protecting hardworking Americans from unscrupulous financial actors," Dodd said. "Yet they were spectators for far too long. "

Foreclosures have accelerated in recent months, especially among homeowners who took out subprime loans, raising worries that many people could lose their homes as mortgage delinquencies mount.

Shares of Countrywide fell 57 cents, or 1.5 percent, to close at $36.38 on the New York Stock Exchange, where those of Fremont General dropped 83 cents, or 8 percent, to close at $9.36.

Shares of Accredited Home Lenders rose 61 cents to close at $12.57 on the Nasdaq Stock Market.

Reasons Why the U.S. Economy is Much More Vulnerable Than it Was in 2001

Mar 21st, 2007

A study recently published by the Bank for International Settlements (Monetary and Prudential Policies at a Crossroad?) says:

“Financial liberalization is undoubtedly critical for the better allocation of resources and long-term growth. The serious costs of financial repression around the world have been well documented. But financial liberalization has also greatly facilitated the access to credit… more than just metaphorically. We have shifted from a cash flow-constrained to an asset-backed economy.”

Though we basically agree with the analysis and the conclusions of the study, we radically disagree with the one sentence that “Financial liberalization is undoubtedly critical for the better allocation of resources and long-term growth.” The indispensable first condition for proper resource allocation at a national as well as global scale is avoidance of excessive money and credit creation. In many countries, and in particular in the United States, they are excessive as never before.

If Mr. Bernanke complains about irregularities of M2, this is nothing in comparison with the fact that credit and debt growth in the United States has exploded for more than two decades. When Mr. Greenspan took over at the helm of the Fed in 1987, outstanding debt in the United States totaled $10.5 billion. In less than 20 years, this sum has quadrupled to $41.9 billion. In reality, this significantly understates the rise in debts because, for example, highly leveraged hedge funds with trillions of outstanding debts are not captured. In 1987, indebtedness was equivalent to 223% of GDP, which was already pretty high. Lately, it is up to 317% of GDP.

In actual fact, there used to be a very stable relationship between money or credit growth and GDP or income growth until the early 1980s. Growth of aggregate outstanding indebtedness of all nonfinancial borrowers - private households, businesses and government - had narrowly hovered around $1.40 for each $1 of the economy’s gross national product. Debt growth of the financial sector was minimal.

The breakdown of this relationship started in the early 1980s. Financial liberalization and innovation certainly played a role. But the most important change definitely occurred in the link between money and credit growth to asset markets. Money and credit began to pour into asset markets, boosting their prices, while the traditional inflation rates of goods and services declined. The worst case of this kind at the time was, of course, Japan.

Do not be fooled by the sharp decline in consumer borrowing into the belief that money and credit has been tightened in the United States. Instead, borrowing for leveraged securities purchases (in particular, carry trade and merger and acquisition financings) has been outright rocketing, with security brokers and dealers playing a key role. Over the three quarters of 2006, their net acquisitions of financial assets have been running at an annual rate of more than $600 billion, more than double their expansion in the past.

Federal funds and repurchase agreements expanded in the third quarter at an annual rate of $606.3 billion, or an annual 26%. The main borrowers were brokers and dealers. During the first three quarters of the year, their assets increased $427 billion, or 27% annualized, to $2.57 billion. A large part of the money came from the highly liquid corporations. There is no reason to wonder about low and falling long-term interest rates.

All this confirms that financial conditions remain extraordinarily loose. Even that is a gross understatement. Credit for financial speculation is available at liberty. Expectations for weaker economic activity only foster greater financial sector leverage. Why such unusually aggressive speculative expansion in the face of a slowing economy?

The apparent explanation is that the financial sector intends to make the greatest possible profit from the coming decline of interest rates, promising further rises in asset prices against falling interest rates. While the real economy slows, the leveraged speculation by the financial fraternity goes into overdrive. Principally, there is nothing new about such speculation. New, however, is its exorbitant scale.

Before leading his jumbo-sized delegation to Beijing, Henry Paulson, U.S. Treasury secretary, cautioned against expecting any big breakthroughs from the visit. And so it has turned out. The meeting produced plenty of statements about the desirability of improving relations, but nothing concrete to do so.

Of course, the Chinese are in a very strong position with the central bank holding more than $1 trillion of bonds in its portfolio, mostly denominated in dollars. According to reports, the American visit was initiated by Mr. Paulson in an effort to contain rising Sinophobia in the U.S. Congress, which increasingly blames China for America’s economic problems, from its huge current account deficit to stagnating real incomes. In other words, those troublemakers, not the trade deficit, are the problem.

One cannot say that U.S. policymakers and economists have been preoccupied with worries about possible harmful effects of the exploding trade deficit. They appear obsessed with the conventional wisdom that free trade is good and must always be good under any and all circumstances, as postulated in the early 19th century by David Ricardo.

Ricardo exemplified this by comparing trade in wine and cloth between Portugal and England. Portugal was cheaper in both products, but its comparative advantage was greater in wine. As a result, according to Ricardo, Portugal boosted its production and exports of wine. In contrast, England gave up its wine production and could produce more sophisticated goods. In both countries, living standards rose.

For sure, it appears highly plausible that American policymakers feel they are following Ricardo’s logic. Only they are disregarding some caveats of Ricardo’s. For equal benefit, first of all, balanced foreign trade is required. “Exports pay for imports” was a dogma of classical economic theory. Ricardo, furthermore, disapproved of foreign investment, with the argument that it slows down the home economy.

With an annual current account deficit of more than $800 billion, the U.S. economy is definitely a big loser in foreign trade. To offset this loss of domestic spending and income, alternative additional demand creation is needed. Essentially, all job losses are in high-wage manufacturing, and most gains are in low-wage services. In essence, the U.S. economy is restructuring downward, while the Chinese economy is restructuring upward.

Considering that Chinese wages are just a fraction of U.S. or European wages, it appears absurd that the Chinese authorities deem it necessary to additionally subsidize their booming exports by a grossly undervalued currency, held down by pegging the yuan to the dollar.

In the U.S. financial sphere, the year 2006 has set new records everywhere: records in stock prices, records in mergers and acquisitions, records in private equity deals, record-low spreads, record-low volatility. Manifestly, there is not the slightest check on borrowing for financial speculation. There is epic inflation in Wall Street profits.

One wonders what can stop this unprecedented speculative binge. Pondering this question, we note in the first place that the gains in asset prices - look at equities, commodities and bonds - have been rather moderate. To make super-sized profits, immense leverage is needed. We think the speculation is unmatched for its scope, intensity and peril. Plainly, it assumes absence of any serious risk in the financial system and the economy. The surest thing to predict is that the next interest move by the Fed will be downward.

In our view, the obvious major risk for speculation is in the economy - that is, in the impending bust of the gigantic housing bubble. Homeownership is broadly spread among the population, in contrast to owning stocks. So the breaking of the housing bubble will hurt the American people far more than did the collapse in stock prices in 2000-02. For sure, the U.S. economy is incomparably more vulnerable than in 2001. Another big risk is in the dollar.

Regards,

Dr. Kurt Richebacher
for The Daily Reckoning Australia

Crash and Bernanke

Financial Times

Published: 20/3/2007 | Last Updated: 20/3/2007 20:45 London Time

"Alan, you're it. Goddammit, it's up to you." On Black Monday 1987, the president of the New York Federal Reserve joined the ranks of those relying on Alan Greenspan during a meltdown. He was not the last. By the time the Fed chairman retired, many believed in the so-called "Greenspan put" – that if markets got really bad the Fed would cut rates and bail investors out.

Today, with nervy markets, is there a Bernanke put? Central banks react to shocks in the real world: the co-ordinated global cut after September 11 is one example. But moral hazard makes underwriting markets a dubious activity. Even so, monetary officials know that unduly tight policy after crashes in the US in the 1930s and Japan in the 1990s may have contributed to economic slumps.

Investors should not be complacent, as the precedents are mixed. The Fed eased after the 7 per cent fall in the stock market on October 13 1989 and cut in 1998 after Russia's default and the Long-Term Capital Management crisis caused bond market jitters. But the liquidity boost in 1987 was aimed at forestalling a payments crisis on Wall Street rather than influencing asset prices. And in 2000, the Fed watched Nasdaq fall by 45 per cent, only signalling an easing in December, when it was more clear that the real economy had slowed.

Now the Fed does not have that much "ammunition". At 2.8 per cent, real rates, defined as the target rate less inflation, are about 50-150 basis points more lax than before the 1989, 1998 and 2000 responses. Whether the Fed now has the inclination to bail out markets is even more debatable. Like Mr Greenspan, Ben Bernanke thinks central banks should not try to burst asset bubbles. Unlike Mr Greenspan, Mr Bernanke also rejected a shoot-from-the-hip approach to market slumps during his academic career. His preferred philosophy of inflation-targeting, with a focus on the degree of spare capacity in the economy, suggests taking action only if market moves clearly signal or threaten a deterioration of the real economy. If the emergency phone from New York rings, Ben may be a little less sympathetic.

Copyright The Financial Times Ltd. All rights reserved.