Down the Real-Estate Hole

Every time the music stops for a moment, someone loses a seat and everyone howls with laughter. But the game of musical chairs in the financial markets is not very funny. The Merrill Lynch boss loses his seat when the third-quarter losses from mortgage-backed securities turn out to be more like $8 billion instead of the expected $4.5 billion. Merrill Lynch was the largest marketer of these complex financial products. If its estimates are off by around 75 percent, are others far behind? No wonder fear is running in the financial world, to wit, that other banks are also facing dramatic losses, hidden in unbelievably complicated and little understood credit products.

The absence of a market price for these thinly traded securities creates huge leeway on the part of management to decide what they were worth. In one chunk of Merrill's supposedly blue-chip mortgage portfolio, the values were slashed by 57 percent. The Financial Times was on the mark with its metaphor describing the valuation process as "pick a number and divide by the chief trader's golf handicap." More chairs are going to be taken away.

Further down. Worse, the value of the securities is still declining. No one is sure where the losses reside, given that the securities have been sold and resold. What we do know is that people have lost faith in the mathematical models by which these assets were valued—and in the rating agencies that estimated the risk, especially since the rating agencies have downgraded $100 billion of this paper, raising the pressure on an even wider set of financial institutions to declare their losses. When a security goes from AAA to junk within a few weeks, there is bound to be a breakdown in the confidence in the ratings.

Much depends on the U.S. property market. If it continues its slide, it will force even further downward revisions of the assumptions underpinning the original credit ratings. The Wall Street Journal analyzed more than 130 million home loans made over the past decade. It found that the riskiest, high-rate mortgages were made not only to borrowers with sketchy credit or stretched finances but also to those in the middle-class and wealthier communities seeking to buy more expensive homes than their incomes would normally allow. High-rate mortgages accounted for 29 percent of the total last year, up from 16 percent in 2004, and second-lien loans, a way of financing the down payment, climbed to 22 percent—nearly double those in 2004. In one Goldman Sachs securitized offering of mortgages, the average loans, including second liens, were 99.29 percent of the purchases, leaving the average equity invested at 0.71 percent.

Some buyers were just speculating. They lined up for these loans, since essentially none of their money was at risk—meaning they could profit if housing prices rose and walk if they tanked, with little to lose. Last year 13 percent of all high-rate loans were for properties not occupied by owners. Then there's the continuing decline in housing prices, estimated to reach an average of at least 10 percent this year, which will wipe out the equity in many homes and produce an estimated 1.7 million foreclosures next year.

What is to be done? Yes, central banks have been helping by lowering interest rates, but rate cuts address the temporary lack of liquidity and not the degrading of asset quality—which is what threatens a systemic catastrophe.

Congress is jumping in with a bill that prohibits "mortgage originators from steering, counseling, or directing a consumer to any residential mortgage that is not in the consumer's interest." This is legislative nonsense. It's the consumer who has to estimate his future income and the affordability of risk associated with fixed versus adjustable interest rates. Given that financiers have shown they can be wrong about their own investments, how can you make them liable for wrong guesses by the consumers?

I have three suggestions.

— Require loan originators to hold at least a percentage of the mortgages. This would give them a motive for greater diligence; they would have a direct stake in the long-run performance of the loans, and their interests would align with the interests of the investors buying the securities.

— The Federal Reserve should look at practices that exacerbated the problem, including excessive penalties for prepayment; the lack of escrow accounts; low-documentation lending; and inadequate borrower repayment standards.

— Investment institutions must find a way to be more transparent in terms of their holdings. A system that disperses risk in such a way that nobody knows who has lost, or how much, is as random in its victims as musical chairs—and a menace to the credit system that lubricates the real economy.