The bubble years

OPINION:

“If we can extend a hand to banks on Wall Street,” Barack Obama told a Wall Street audience in New York last week, “we can extend a hand to Americans who are struggling through no fault of their own.”

“Well, if the [Federal Reserve] can extend $30 billion to help Bear Stearns address their financial crisis,” Hillary Clinton declared in Philadelphia last week, “the federal government should provide at least that much emergency assistance to help families and communities address theirs.”

Federal Reserve Chairman Ben Bernanke and Treasury Secretary Hank Paulson had to know that the bankruptcy-preventing lifeline they extended to the Bear Stearns investment bank last month would elicit demands that federal coffers be opened up to millions of “homeowners” facing mortgage-payment problems because they gambled on ever-rising home prices — and lost. Clearly, it did not take Mr. Obama or Mrs. Clinton very long to issue such a demand.

While he was in New York, Mr. Obama should have asked Bear Stearns workers (many of whom are constituents of Mrs. Clinton and who collectively owned about a third of the investment bank) and other Bear shareholders if they thought the $10 per share eventually offered by JPMorgan Chase for Bear Stearns stock represented a “bailout.” The $1.2 billion purchase price for Bear Stearns amounts to about 10 percent of the firm’s stockholders’ equity as of last November and less than 7 percent of Bear’s market price of $150 per share that prevailed earlier last year.

Had Bear Stearns been permitted to go bankrupt, the settlement of the notional trillions of dollars — yes, literally trillions (reportedly $13.4 trillion) — in counterparty financial arrangements (credit default swaps and other financial derivatives) involving Bear, on the one hand, and other banks and investors, on the other, would have almost certainly produced prolonged chaos, threatening to make the current credit-market crisis look like a tea party. To entice JPMorgan to purchase Bear, the Fed felt compelled to assume the risk of nearly $30 billion in potentially worthless assets on Bear’s balance sheet. Messrs. Bernanke and Paulson evidently decided that guaranteeing protection for roughly $30 billion worth of claims on Bear by bondholders and other creditors was a price worth paying if the alternative was a potentially massive meltdown throughout the entire financial system.

Compared to the potential — indeed, the likely — losses in the value of the nation’s housing stock, $30 billion is a pittance. By demanding that taxpayer funds be put at risk to bail out untold millions of “homeowners” who made ill-advised, irresponsible, risky bets near the peak of the housing bubble or who used their homes as an ATM machine (or both), Mr. Obama and Mrs. Clinton would expose the federal government and prudent, responsible, taxpaying homeowners to astronomical risk. Make no mistake about it: The relatively modest bailout numbers being bandied about today by Mr. Obama and Mrs. Clinton represent the proverbial camel’s nose entering the tent.

Moreover, adoption of their “homeowner”-bailout policies would prevent the deflation of the housing bubble from proceeding apace. If housing prices are not permitted to fall from their unsustainable, sky-high perches and not allowed to reach their equilibrium levels, then a long-term, sustainable housing recovery will not begin. Any effort to prevent market-driven declines in home prices from taking place will merely prolong a situation in which millions of responsible households that did not make risky bets will continue to be unable to afford to buy a home.

Truth be told, if homes experience peak-to-trough price declines of the magnitude that many economists now think likely (i.e., 25 to 30 percent), then neither the federal government nor the relatively undercapitalized banking system possesses the financial resources to rescue the untold millions of homeowners who made highly risky bets or acted utterly irresponsibly. Putting little (e.g., less than 5 percent) or no money down; borrowing excessive amounts that could be affordably amortized only by a low, introductory teaser interest rate subject to increase; lying about one’s income to “qualify” for a “liar’s loan”; using “piggy back” loans to finance a down payment; repeatedly refinancing in order to withdraw equity as housing prices soared — all of these tactics constitute risky or irresponsible behavior. And they all became pervasive during the late stages (2004-2006) of the bubble years.

Between the beginning of 2000 and the middle of 2006, average housing prices, according the S&P/Case-Shiller national housing index, increased 93 percent. In some markets, the increase was much higher: Miami, 180 percent; Los Angeles, 175 percent; Washington, D.C., and San Diego, 150 percent. Consumer prices increased by 21 percent during this six-and-a-half-year period. Since mid-2006, national prices have declined 10 percent, while prices in Los Angeles and Miami have fallen nearly 20 percent. With year-over-year existing-home sales and new-home sales down 24 percent and 30 percent, respectively, in February, it would appear that the price correction still has some way to go.

A peak-to-trough price correction of 30 percent would reduce the value of the nation’s housing stock by a staggering $6 trillion. Future editorials will examine the specific proposals of all three presidential candidates.