The origins of a housing credit bubble; Monday-morning quarterbacks are finding plenty to blame for the creation of a housing credit bubble that has dramatically brust. While there's a growing laundry list of causes, there appears to be emerging consensus on some primary drivers, such as monetary ploicy and the unchecked expansion of mortgage credit by non-banks. This two-part series examines the details

Mortgage Banking, Sept, 2008 by Robert Stowe England

As bubbles go, this one is probably going to be a modern record-breaker.

* The worldwide toll in write-downs at banks and financial institutions for the housing credit bubble in the United States is now expected to top out at $565 billion, according to the Washington, D.C.-based International Monetary Fund's (IMF's) latest semi-annual Global Financial Stability Report released this past spring. This figure for the rising toll from the mortgage market's troubles is much higher than the then-alarming prediction of a $400 billion loss early this year from Jan Hatzius, chief economist at Goldman Sachs & Co., New York.

* Indeed, the global-contagion effect from the U.S. mortgage meltdown is expected to approach an eyebrow-raising trillion dollars--or more precisely, $945 billion, according to the IMF.

* Besides the $565 billion in losses on U.S. mortgages, there is a projected $240 billion in losses on debt backed by commercial real estate, $120 billion in losses on corporate loans (such as leveraged buyouts) and $20 billion in losses on consumer loans and credit cards, the IMF calculates. The other kinds of debt lost value as investors fled highly leveraged investments of all types while managers of hedge funds and a range of financial institutions sold assets to improve liquidity.

* The IMF was fairly blunt in its assessment of the contagion effect: "What began as a fairly contained deterioration in portions of the U.S. subprime market has metastasized into severe dislocations in broader credit and funding markets that now pose risks to the macroeconomic outlook in the United States and globally."

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The final tally of the bursting of the bubble should also include the meltdown in the equity markets around the globe--with an estimated $7.7 trillion loss by early this year, according to Charlotte, North Carolina-based Bank of America's chief market strategist Joseph Quinlan.

A global loss of 14.7 percent in equity values from the peak in October 2007 through the end of January exceeded the losses in prior global crises in recent decades, Quinlan calculated, including the next biggest loss leader: a 13.2 percent loss in equity values three months after the collapse of the hedge fund Long-Term Capital Management in 1998. It was also higher than the 9.8 percent plunge three months after Wall Street's Black Monday in October 1987.

Then there's the cumulated $880 billion loss in home equity in the United States reported by the Federal Reserve's estimate for the first quarter of 2008. According to the Fed data, released in June, Americans' equity in their homes represented just 46.2 percent of their properties' market values in the first quarter--the lowest level reported in more than 50 years.

Such staggering losses from the housing credit bubble raise the obvious questions: Why did this happen? What caused it? What important lessons can we learn from this experience to shape future policies and practices?

"Looking back, enormous mistakes were made," says Lyle Gramley, former Fed governor and senior economic adviser at the Stanford Group, Washington, D.C. "If you look for villains, there are lots of them," Gramley says. He then runs down a list, including "economists like me who didn't understand what was going on; borrowers, lenders, credit-rating agencies, financial investors here and abroad; the Federal Reserve and other federal agencies for not using the regulatory powers they had," he adds.

A compelling laundry list of ingredients for the witches' brew that led to the credit bubble is offered by Mark Zandi, chief economist at West Chester, Pennsylvania-based Moody's Economy.com. "We should all recognize that we are all a party to this mess," he says. "First there is the borrower, and certainly the [real estate] investor, the flipper. Many were disingenuous [about their income, job and savings], perhaps bordering on the fraudulent, when they applied for their loans," he says.

"Many current homeowners knew they were getting in over their heads, but hoped that house prices would continue to rise and [they would be able] to get out in the end," he says.

The lenders are also to blame, says Zandi. "They were complicit in the borrowers' sleight of hand," he says. "In many cases they were aggressive fly-by-night lenders, finance companies that were lightly regulated," he says.

Wall Street is also to blame, Zandi says. "The investment banks [that] took the loans and packaged them" ran their operations like a machine "set on autopilot," he says. "They didn't think about the risks involved and who was taking [them]. They didn't do due diligence on loans put into securities. They thought that by tranching it up, it would all work out," he says.

"Securitization broadly" must also be faulted, says Zandi. "It has lots of pluses," he says, "but the big negative is that it left everyone off the hook. No one at the end of the day had responsibility for credit risk."

The credit-rating agencies also played a contributing role, Zandi says. "I don't think anything nefarious was going on," he adds. While people have been saying that the dealers who put together the securitizations were engaged in "ratings shopping," Zandi does not think that is the problem.