Doomed!

We avoided The Perfect S**tstorm just in the nick of time this week, thanks to the government bailout of American International Group (AIG). That is not to say that the worst of the liquidity/credit crisis is over, just that we’ve avoided a sudden and terrible climax to it. We may yet see the credit system in the United States come crashing down, taking with it financial institutions from across the globe and initiating a universal economic depression.

To figure out what happened let’s climb into the Wayback Machine and set the dial for 2005. We arrive in, for the sake of argument, Scottsdale Arizona, a prosperous suburb of Phoenix and one of the most desirable mixed residential and commercial communities in the United States.

A glance at the Arizona Republic or Craig’s List tells us that housing costs, which have always been moderate for this area (since incomes are moderate, at best) are starting to soar. Property owners are being told by real estate agents and mortgage lenders that their homes could list for double and triple what they would have brought a mere five years ago. Homes bought at $300,000 are now worth $700,000. Why not sell now, make a killer profit, and buy some more houses, flip them and make even more profit?

The real estate in the desert at the edges of town is becoming hot property in ways other than temperature as well. Take a parcel of land, develop it for condominiums and sell 2,500 square foot units for $600,000 and $800,000! Construction costs are holding steady, so this looks like a wonderful way to get rich quick.

Now whether you want to buy houses to flip them, or to live in, or if you want to build luxury condos in the middle of the jumping cactus fields as an investment, you will need capital, i.e. money. This means establishing credit and obtaining a loan…a mortgage.

Nothing surprising there, but home values have outpaced earnings drastically. Where real estate values have jumped by 100 and 200 percent, wages and earnings have increased, oh, maybe 10 percent in the same period of time. These wage earners still need places to live and many want to make money in the real estate boom.

The banking industry makes a substantial portion of its earnings by writing loans for residential and commercial properties. With a real estate boom on there is a lot of business to be had. Soon the airwaves are buzzing with countless ads from banks, credit unions and acceptance corporations telling you that if you want credit, you can not only get it, but that banks will fight for the chance to lend you the money!

To attract business the stringent risk assessment process by which your ability to pay was measured is being relaxed. For some categories of borrowers special interest rates below prime are being made available. Banks are writing loans that are not secured by anticipated future earnings of the borrowers, and which rely on the current rising values of real estate during the boom.

It seems risky, but isn’t it a truism that real estate prices only go up? Even if a borrower defaults the foreclosure value of the property, given the current rate of growth of property values insures the lenders are not going to lose money. What is more likely is that everyone gets rich.

Back on Wall Street great corporations are buying investment portfolios based on this massive wave of mortgage lending. In fact, they are going “all in,” putting all their chips on exotic investment instruments --derivatives-- based, ultimately, on poorly secured residential mortgages. A measure of solace for the stockholders of these corporations is provided by AIG, which is doing a land office business writing insurance for these investments.

Back in our own time, it is obvious something has gone unexpectedly and dreadfully wrong.

The people who have been renovating houses to flip them are now unable to find buyers for their properties. The condos out on the desert the edge of Scottsdale are standing vacant. All signs of a real estate boom are missing.

Except it wasn’t a real estate boom; it was a bubble, and it has burst.

Without a buyer for the house he renovated the would-be Bob Vila cannot make the payments on the mortgage he got when banks fought for his business. During his struggles he probably got equity lines of credit on the house he wants to flip and his own residence which he has maxxed out. His credit card revolving debt is probably in the low five figures. There’s no way he can make the payments. He goes to foreclosure and the value of the properties do not make good the loss to the bank. The investors who built the condominiums are losing money on property taxes and defaulting on their mortgages.

AIG offered insurance on derivatives built on other derivatives built on mortgages. When real estate prices declined by 10 to 20 percent, these derivates in some cases declined in value by 100 percent! The people holding these exotic investment instruments based on mortgage lending are now flooding AIG with claims. AIG essentially insures the entire credit industry of the United States. The claims have exhausted AIG's liquidity...there's no more money to pay claims.

If they cannot meet their obligations then a credit blackout effecting every kind of borrowing from bank credit cards at the supermarket through mortgages will paralyze the economy. With no one to insure credit, no one will risk extending credit.

Now other factors enter into play, making this The Perfect Economic S**tstorm. The big one is energy costs. With the cost of light, heat and transportation increasing exponentially for American business, belt-tightening is in order –especially if the business in question has had failed investments in real estate! Belt-tightening means firings, layoffs and work reductions. Aside from more foreclosures, this means less consumer spending which means, in turn, layoffs and business failures in a wide range of industries supplying consumer goods, and fast-rising unemployment.

The federal bailout of AIG has postponed, maybe prevented, a credit collapse. Is that the happy end of the story? I doubt it.