The subprime mortgage crisis grows more serious evey day in the US, and is beginning to affect sectors outside of financial insistitutions. Apparently the banks have not been upfront with the investment community about the extent of the problem on their balance sheets. Each day, the write-offs are revised upward and have claimed the CEOs of Merrill Lynch and Citi (even though the disgraced managers were handsomely rewarded for losing $$billions at their respective insitutions). But the shockwaves are being felt in the real estate market, as prices fall at historic rates. SInce Americans have been encouraged for years to borrow against the "equity" in their homes through home equity loans, the next big crisis will involve second and third mortgages and lead to a another, much larger, wave of home foreclosures, which in turn will collapse prices further. Lawrence Summers (former US Treasurer and ex-president of Harvard) is one of the few who has sounded the alarm at the growing economic crisis:
Several streams of data indicate how much more serious the situation is than was clear a few months ago. First, forward-looking indicators suggest that the housing sector may be in free-fall from what felt like the basement levels of a few months ago. Single family home construction may be down over the next year by as much as half from previous peak levels. There are forecasts implied by at least one property derivatives market indicating that nationwide house prices could fall from their previous peaks by as much as 25 per cent over the next several years.
We do not have comparable experiences on which to base predictions about what this will mean for the overall economy, but it is hard to believe declines of anything like this magnitude will not lead to a dramatic slowing in the consumer spending that has driven the economy in recent years.
Nor are we anywhere near the end of the subprime disaster: another $500 billion of adjustable rate mortgages will reset by March 2008. The impact will severely weaken banks and depress the credit card, car loans, and commercial property markets.
The downward spiral is being felt in Germany. Earlier I wrote about the forced taxpayer bailout of IKB Bank - one of the first German banks ensnared in the subprime crisis. In August the cost of the bailout was about €3.1 billion, but now it looks like the bailout has nearly doubled to €6.1 billion. But is that the end? What is the total exposure of German investors and banks in the US commercial real estate market, and what will happen if there is a 25% "correction" in real estate values over the next 3 years? Of course, the situation is made worse as the value of these investments on German balance sheets decline with the weakening US dollar.
Why did the German banks put so much of their capital at risk in the US mortgage market? My old boss, Klaus Peter Mueller - the smartest banker I know - points to one reason in an interview with the International Herald Tribune:
Beyond that, Müller said, banks need to think about what pushed them into the subprime market. In most cases, he said, it is home banking markets that lacked the effervescent returns of these investments.
"Effervescent returns" is a euphemism for Greed. Beyond this K-P Mueller points to a conflict of interest which now, in hindsight, seems so blindingly obvious:
Müller said he did not yearn for a European ratings agency to counter the influence of Standard & Poor's and Moody's Investors Service, both based in New York. But he said the agencies should no longer help banks put together packages of securities, and then rate those investments.