Home prices drop, worsen credit crisis

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The credit and housing crisis deepened yesterday amid reports of a record 3.5 percent drop in home prices during the spring and a resurgence of subprime defaults this summer after millions of mortgages reset at dramatically higher payment rates.

The mounting credit crunch provoked the biggest drop in consumer confidence in two years during August and undermined what had been a tentative revival of stocks yesterday, with the Dow Jones Industrial Average plummeting 280 points. The market plunge accelerated in midafternoon after a report from the Federal Reserve showed it appeared to underestimate the extent of the credit crisis earlier this month on Wall Street.

The drop in consumer confidence reported by the Conference Board yesterday offered the first clear evidence that consumers are reacting to the worsening housing and credit situation, raising fears that the cutoff of easy-to-get home loans and refinancings will have an impact on consumer spending and the broader economy.

"Consumers are obviously paying attention to what's going on and are a little worried by it," said Adam York, an economist at Wachovia Corp. "We are not expecting them to spend the way we thought they would a few months ago."

Contributing to the consumer malaise was a record 3.5 percent drop in home prices in 20 major metropolitan areas during the spring quarter, according to the S&P/Case-Shiller index published yesterday. Falling house prices make it harder for consumers to sell and refinance their homes while erasing some of the home equity they were relying on heavily in recent years to finance a spending splurge.

While consumers are increasingly focused on the deteriorating housing and credit situation, the Fed remained focused on its fight against inflation at a meeting Aug. 7, just days before the credit crunch escalated into a market rout on Wall Street, according to minutes from the meeting released yesterday.

Although the Fed said it was closely watching the market turmoil and making contingency plans in case it deepened, cascading losses on Wall Street forced the central bank to reverse course and mount a major market rescue operation within 10 days. By Aug. 17, the Fed was slashing its emergency lending rate for banks and providing tens of billions of dollars of cash infusions into the markets each day to maintain liquidity.

"The mistake the Fed made is that the market was clearly coming unglued prior to the meeting," said Scott Minerd, an investment manager at Guggenheim Partners. By maintaining its stance that inflation was the greatest concern, "it telegraphed to the market that this Fed was really out of touch with how severe the credit dislocation was."

The Fed's lack of concern about the tightening of credit was particularly upsetting to stock investors, who have been counting on the Fed to provide an economywide cut in interest rates to safeguard the economy and limit losses on Wall Street.

The Fed minutes showed that central bankers thought credit-worthy businesses and consumers were still easily able to obtain loans, although it noted in the days just before the meeting home buyers who needed jumbo mortgages of more than $417,000 were starting to encounter difficulties. The minutes make no mention of the commercial-paper market, where short-term lending to some businesses has come to a standstill.

The Fed noted that lending to subprime borrowers had virtually dried up, but seemed unfazed and even approving of the much tighter credit terms and higher interest rates those borrowers likely would have to pay in the future.

Unprecedented levels of default on subprime mortgages are what triggered the credit crisis, and news released yesterday indicated that they worsened substantially this summer as many of the borrowers were unable to cope with exploding monthly payments on loans they took out in the second half of 2005 when the housing boom and house prices peaked.

The default rate on those loans climbed to 17.5 percent last month from 15.7 percent in June, according to Wachovia Corp. estimates. The default rate on loans taken out during the first half of 2006 — which have not reached the point of resetting to reflect higher market interest rates and deferred principal payments — rose to 14 percent from 12.4 percent.

Most subprime loans are structured so that after a two-year period of introductory rates as low as 1 percent or 2 percent, the rates rise by three percentage points or more — causing a doubling or more of the monthly payment. Most borrowers do not have the incomes to support such higher payments, and they may not be able to refinance out of the loans because the value of their home has dropped below the principal amount or because subprime lenders have gone out of business and funds for refinancing have dried up.

As defaults and foreclosures among subprime and other borrowers escalate, the Wall Street investment houses that arranged most of the financings, repackaged the loans and sold them to investors have been hit hard. The stocks of investment houses like Lehman Brothers and Bear Stearns & Co. have lost more than 30 percent of their value this year.

A report from Merrill Lynch & Co. yesterday suggested the news may get worse for the big banks and powerhouses, as their losses from defaulting mortgages are no longer likely to be offset by booming revenue from buyouts and mergers, which have been slowed and scaled back dramatically by the financing crunch. The darker outlook for the investment firms led to losses in the stock market yesterday.