A mortgage crisis that didn't have to be

It's not a pretty picture, and it didn't have to come to this.

The worst housing slump since World War II is showing no sign of abating. Manufacturing activity is hinting at recession. Employment is weakening. The stock market has fallen dramatically. The mistakes banks and brokers made with mortgage-related bonds have left a lingering credit crunch, or a reluctance by lenders to make affordable loans to consumers and businesses.

Investors have gone into the new year with a dreary attitude, and Wall Street analysts are warning investors to be careful.

"Batten down the hatches," Lehman Bros. Holdings Inc. economist Michelle Meyer said in a recent report.

Meyer estimates that the housing mess, which set off the economy's problems, is only half over, and that home prices will be down at least 15 percent when they hit bottom in 2009.

Only about 1.5 million of the most troubled mortgages, or adjustable-rate subprime loans, have reset to higher monthly payments so far. Meyer is expecting an additional 2.8 million in the next two years. With those resets, homeowners typically will have to pay about 30 percent more than they do now, a difficult nut for anyone, and especially for subprime borrowers, who were financially stressed in the first place.

To make matters worse, options are dwindling for the people who will be strapped. About half of the borrowers have less than 10 percent equity in their homes, said Meyer, and as foreclosures quadruple to about one million in both 2008 and 2009, the supply of discounted homes on the market will cause prices to fall further.

Of course, falling prices mean dwindling equity in a home. So homeowners caught with a higher mortgage payment will not have the equity they need to refinance and escape. The result will be more foreclosures and more fire sales in an already-glutted home market.

The questions hanging over the economy, and consequently the stock market, are: How badly will the housing mess spiral through the economy? Will homeowners feel poor and spend less? Will that crimp corporate profits and induce layoffs?

And as a new round of subprime-mortgage defaults strips the value out of mortgage-related bonds and loans held by banks and brokers, will that cut into their willingness to lend money to those who want or need it? Already, the financial institutions have been hobbled to some extent by $50 billion in write-downs.

Certainly, if this cycle turns out as bad as some imagine, analysts will look back at a plethora of warnings that should have been taken seriously.

Homeowners did not have to overdose on mortgage debt they could not afford. Mortgage lenders did not have to push poisonous adjustable-rate loans at homeowners when they knew the individuals could not afford them.

Wall Street investment banks did not have to ignore the poison, while bundling the mess into the esoteric bonds that eventually would set off a credit crunch. Investors who bought the bonds did not have to be as naive as the homeowners when they indulged, without question, in a financial product they did not understand. Bond-rating firms, which are supposed to safeguard investors by probing into the construction of bonds, did not have to swallow Wall Street's numbers and give the toxic stuff a stamp of approval.

And Congress and banking regulators did not have to ignore consumer advocates, who have been testifying for years that abusive mortgage-lending practices eventually were going to cause millions to lose their American dream.

Ironically, some of the early warnings came from within the investment-banking firms that gained so much over the years creating bonds out of mortgage payments and then suffered recently as homeowners defaulted and the bonds plunged in value.

While not forecasting problems specifically for banks, Merrill Lynch & Co. Inc. economist David Rosenberg was among the economists sounding the early warnings. In September 2004, he said there was a clear housing bubble, and it could turn ugly.

When Rosenberg wrote his report, home prices in such markets as San Diego and Los Angeles already had climbed 80 percent, and Rosenberg described classic bubble characteristics: overheated prices; over-ownership; too much debt; speculation; complacency; denial.

He noted that subprime lending to people with lower credit scores and incomes had risen 25 percent on average throughout the decade, and that lenders could be at risk if people could not make payments or sell their homes in a weakening economy.

The ARM lending craze set off a spiral of financial stress, said Kathleen Keest, senior policy counsel for the Center for Responsible Lending.

As early as 1999 to 2000, consumer advocates were tracking what Keest calls a "foreclosure crisis," in which one in four homeowners were unable to handle payments.

"The industry wouldn't listen," she said.