Did Bernanke Get It Wrong

From Bloomberg this morning:

Bernanke Was Wrong: Subprime Contagion Is Spreading

Federal Reserve Chairman Ben S. Bernanke was wrong.

So were U.S. Treasury Secretary Henry Paulson and Merrill Lynch & Co. Chief Executive Officer Stanley O'Neal.

The subprime mortgage industry's problems were contained, they all said. It turns out that the turmoil was contagious.

The $2 trillion market for mortgages not backed by government- sponsored agencies is at a standstill. That's just the beginning. Other types of mortgages are suffering. So are firms and banks that package the debt for investors. The ripples were felt in Europe and Asia, where central banks offered cash to banks amid a credit crunch. And some corporations, from countertop makers to railroads, are blaming the mortgage meltdown and housing slump for earnings that fell short of analysts' estimates.

Even a mobile-phone company, Dallas-based MetroPCS Communications Inc., says it's feeling the pinch from customers facing foreclosure. And experts such as William Ford, former president of the Federal Reserve Bank of Atlanta, say the chance of a recession is growing.

``Housing created a lot of ancillary economic activity and jobs, and now we are in the reverse process,'' says Paul Kasriel, chief economist at Northern Trust Corp. in Chicago and a former Fed economist.

The European Central Bank today made a second loan to banks to alleviate a money shortage sparked by concerns over investments in U.S. mortgages. Today's loan of 61.05 billion euros ($83.4 billion) brings the two-day total of money lent to 155.85 billion euros ($212.9 billion).

The ECB's unprecedented move followed the freezing of three funds managed by BNP Paribas, France's largest bank, because the bank couldn't calculate how much the funds' holdings were worth due to a lack of buyers.

Today, the Bank of Japan made similar moves to supply cash.

`Spreading to Banks'

``The subprime mess is now spreading to banks,'' says Nariman Behravesh, chief economist at Global Insight Inc. in Lexington, Massachusetts. ``A lot of international banks, especially those in Europe, did invest a lot in the collateralized debt markets, especially the subprime situation here in the U.S., so they're suffering.''

Peter Lynch, chairman of private equity fund Prime Active Capital Plc in Dublin, said the ECB was ``treating this like an emergency.''

Bernanke told Congress on March 28 that subprime defaults were ``likely to be contained.'' The Fed chief, who declined to comment for this story, changed his assessment last month.

On July 18, he told Congress that ``rising delinquencies and foreclosures are creating personal, economic and social distress for many homeowners and communities -- problems that likely will get worse before they get better.''

Paulson Comment

Paulson said June 20 that subprime fallout ``will not affect the economy overall.''

This week on CNBC, he provided a less definitive assessment, saying that markets have been ``unsettled largely because of disruption in the subprime space.''

``We've had a major correction in that housing sector,'' Paulson said. ``It will take a while for the impact of that to ripple through the economy as mortgages reset.''

O'Neal on June 27 called subprime defaults ``reasonably well contained.'' Merrill spokeswoman Jessica Oppenheim said this week that the company is confident his words accurately reflected the market at the time. O'Neal declined to comment.

Among the other executives joining the chorus was Bank of America Corp. CEO Kenneth Lewis, who said June 20 that the housing slump was just about over.

``We're seeing the worst of it,'' Lewis said.

`Broader Fallout'

Within the week, he was contradicted by a team of Bank of America analysts, who called losses in the mortgage market the ``tip of the iceberg'' and predicted ``broader fallout'' from adjustable-rate loans resetting at higher interest rates.

David Olson, president of Wholesale Access Mortgage Research & Consulting Inc. in Columbia, Maryland, is blunt about his current outlook. He says a third of the U.S. home-loan industry will disappear.

With last week's collapse of American Home Mortgage Investment Corp., which sold $58.9 billion of loans to borrowers in 2006, the subprime contagion spread to so-called Alt-A mortgages, which are available to borrowers with good credit who don't want to verify their income with tax forms or pay stubs.

American Home couldn't find Wall Street firms willing to buy these mortgages and package them into securities because of rising defaults. The Melville, New York-based company filed for bankruptcy Aug. 6.

``This is just the first, because all the Alt-A guys are going to go,'' Olson says. ``This is the most difficult mortgage environment I've seen in my 40 years in the business.''

This grade of loan made up 13 percent of all mortgages last year, according to Inside Mortgage Finance. Combined with subprime, they account for a third of the market. Both types of loan are rapidly disappearing.

Housing Prices

U.S. housing prices will fall this year, the first annual decline since the Great Depression of the 1930s, according to the National Association of Realtors, based in Chicago.

The inventory of unsold U.S. homes in May was the largest since the realtors group started counting them in 1999. Defaults and foreclosures may increase because about $1 trillion of payments on adjustable-rate mortgages are scheduled to rise this year, hitting a peak in October, according to Credit Suisse.

Housing and related industries generate almost a quarter of U.S. gross domestic product, according to the Joint Center for Housing Studies at Harvard University in Cambridge, Massachusetts.

The mortgage fallout ``ensures the economy will grow well below its potential through the remainder of the year and next,'' says Mark Zandi, chief economist for Moody's Economy.com in West Chester, Pennsylvania, who predicts GDP growth of 2.5 percent this quarter and next. Second-quarter growth was 3.4 percent.

Lowered Forecast

Demand for loans to bundle into mortgage-backed securities came to a halt, crippling the subprime and Alt-A lending businesses. The exception was prime loans conforming to rules set by the biggest government-chartered agencies, Fannie Mae in Washington and Freddie Mac in McLean, Virginia.

Doug Duncan, the Mortgage Bankers Association's chief economist, says he's lowering the group's forecast on the total dollar value of new U.S. mortgages.

The association said July 12 that the value of mortgages sold would decline 7 percent this year to $2.6 trillion and 18 percent in 2008 to $2.3 trillion, from $2.8 trillion last year.

``Most of the market has shut down,'' Duncan says. ``This is not a normal event.''

Peter Hebert, a broker with Houston-based Allied Home Mortgage Capital Corp. in Ellicott City, Maryland, says it's getting tougher to find mortgages for his clients.

`Use a Credit Card'

For one self-employed borrower in Pennsylvania, with a 626 credit score, just above what's considered subprime, Hebert says he contacted three lenders. Last year, the borrower would have qualified for a 7.99 percent loan, Hebert says. This week, he received one offer for a 10.5 percent loan with a three-year prepayment penalty, meaning that if the borrower refinanced during that time he would be required to make six months of payments to the original lender.

``It would have been cheaper to use a credit card to pay for his house,'' Hebert says.

When it came time to lock in the rate, the lender pulled out, Hebert says.

``It was a hard thing to do, an emotional thing, to tell my borrower he was turned down for a rate that was high to begin with,'' he says.

Margin Calls

The market is shifting, too, for firms that package loans into securities and sell them to investors. About $11.2 billion of private-label, or ``non-agency'' mortgage bonds -- those not guaranteed by Fannie Mae, Freddie Mac or Washington-based Ginnie Mae -- were sold in July, according to Michael D. Youngblood, portfolio manager and analyst at Friedman Billings Ramsey Group Inc. in Arlington, Virginia. That's down from $41.6 billion in June and from a monthly average of $86.6 billion this year.

Luminent Mortgage Capital Inc., a San Francisco-based firm that packages mortgages for investors, cited ``a significant increase in margin calls'' for canceling its dividend.

Such firms borrowed money from banks to buy loans to create securities. When investors stopped buying the securities, the banks that made the original loan demanded their money back.

Many such firms that package securities will leave the business this year, says Guy Cecala, publisher of Inside Mortgage Finance.

``If you're an investment bank and you're losing stock value every week because of your connection to the mortgage industry, isn't it easier to cut ties?'' Cecala says.

Bank Stocks

Shares of the top 12 U.S. banks have declined 17 percent since June 1.

Yesterday, Countrywide Financial Corp., the biggest U.S. mortgage lender, said in a filing that ``unprecedented disruptions'' in the U.S. home-loan market may crimp its ability to lend. The company said it may be forced to retain more of the loans it makes to homeowners rather than selling them to investors and that it may have difficulty obtaining financing from its creditors.

Corporations outside the mortgage industry are taking a hit, too, as housing slumps. Burlington Northern Santa Fe Corp., the second-biggest U.S. railroad, said it shipped less lumber for homebuilding in the second quarter. DuPont Chief Executive Officer Charles O. Holliday Jr. said July 24 that the housing recession eroded demand for Tyvek weather barriers, used in 40 percent of new homes, and Corian countertops.

Steak n Shake

Steak n Shake Co., an Indianapolis-based fast-food chain, blamed a 4.3 percent decline in same-store sales in the third quarter partly on credit markets. ``Some segments of Steak n Shake consumers continue to be sensitive to high gasoline prices and mortgage interest rates,'' the company said in a statement yesterday.

Shares of MetroPCS, a prepaid mobile-phone service, fell 20 percent Aug. 3 after second-quarter sales missed analyst estimates. Chief Financial Officer J. Braxton Carter blamed customers' ``short-term economic disruptions,'' such as defaulting on their subprime loans.

As for the faulty initial predictions by Bernanke and others, go easy on them, says Josh Rosner, managing director at the New York investment research firm Graham Fisher & Co.

``There's no model for what's happening now in the housing and mortgage industries,'' Rosner says. ``We have to give Bernanke a chance. He is a reasoned and traditional central banker. He knows how to manage crazies.''