US ponders: How deep is economic abyss?
Updated: 2008-03-24 11:07
As long as housing prices went up, the strategy worked. When they began to crumble, so did financial stability.
The same people who made a financial stretch to buy their homes are now defaulting on the loans at alarming rates. Many are "upside down" on their loans, meaning they owe more on their mortgages than their homes are worth.
Nearly 9 million households now have upside-down mortgages, and for the first time ever, aggregate mortgage debt is bigger than the total value of homeowner equity - bigger by $836 billion, according to research by Merrill Lynch.
The housing problem set off the dominoes: Surging defaults meant the mortgage-backed securities plunged in value. That dried up the money to fund new home loans, and lenders everywhere became tighter with credit.
Bear Stearns found itself in the cross hairs. Market rumors began to swirl about the size of its exposure to mortgage securities, whether it had ample reserves to cover potential losses. Clients and investors began to demand their money back.
"This problem begins with the fact that we underwrote mortgages sloppily, which means no one really knows what those assets are worth," said Lyle Gramley, a former Federal Reserve governor and now an analyst with Stanford Financial Group. "That makes bankers very leery, and has resulted in a significant contraction in the availability of credit."
The credit crunch means corporations can't borrow as easily, so they are delaying big projects, which cuts into the job market. And many of the same companies were already smarting from the downturn in housing, which has made many Americans uneasy about their household wealth and caused them to scrimp on spending.
The last time the US economy tilted into recession was 2001. And it was an entirely different animal.
Investors bore the brunt of that downturn as the stock market shook off the excesses of the late-'90s technology boom. Encouraged by their government - and fortified with tax rebates in their pockets - Americans kept spending.
Perhaps most importantly, there was no reason for anyone to doubt the stability of the financial system. There was no credit crisis to speak of, and the housing boom had yet to begin.
This time around, no one has declared a recession just yet: By the generally accepted rule, that takes two consecutive quarters of shrinking economic activity. The economy came close to stalling late last year but eked out small growth.
But the lack of an official declaration makes the pain no less real.
"I think the current financial crisis looks to me like the worst one since we got into the Depression," says Richard Sylla, who teaches the history of financial institutions at New York University's Stern School of Business.
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