All major panics follow the same basic outline: asset bubble, massive leverage (borrowing to buy the rising asset), bursting bubble (asset price declines rapidly), defaults on loans, asymmetric information and uncertainty, reduced lending, declining economic activity, unemployment, more defaults.
For the second time in seven years, the bursting of a major-asset bubble has inflicted great damage on world financial markets. In both cases—the equity bubble in 2000 and the credit bubble in 2007—central banks were asleep at the switch. The lack of monetary discipline has become a hallmark of unfettered globalization. Central banks have failed to provide a stable underpinning to world financial markets and to an increasingly asset-dependent global economy.
The present housing debacle should teach home buyers, lenders, brokers and government some simple lessons that will ensure stability in the future. Home purchases should involve an honest-to-God down payment of at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified.
As calamitous as the sub-prime blowup seems, it is only the beginning. The credit bubble spawned abuses throughout the system. Sub-prime lending just happened to be the most egregious of the lot, and thus the first to have the cockroaches scurrying out in plain view. The housing market will collapse. New-home construction will collapse. Consumer pocketbooks will be pinched. The consumer spending binge will be over. The U.S. economy will enter a recession."
This began with a major under assessment of risk in mortgage lending, but extended via securitized mortgage debt instruments to the rest of the financial sector here and abroad.
Many new types of mortgages were made on the expectation that rising home prices would cover over any problems related to lending to 'subprime' borrowers. When home prices began to fall, an unexpectedly high percentage of homeowners began to default. That caused major problems throughout the global financial system because of the widespread practice of 'securitizing' mortgages, of lumping them together, slicing them into risk-adjusted pieces called 'tranches,' and selling them to investors throughout the world.
Home ownership is a wonderful thing. My family and I have enjoyed my present home for 50 years, with more to come. But enjoyment and utility should be the primary motives for purchase, not profit or refi possibilities. And the home purchased ought to fit the income of the purchaser.
