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Economic crisis, step by step: Consequences could be brutal in Morgan county(The Decatur Daily (AL) Via Acquire Media NewsEdge) Oct. 12--The origins of the economic crisis had little to do with Decatur, but its consequences here could be brutal. Understanding how the crisis arose helps explain the peril that has traveled from overbuilt housing markets to Wall Street to Sixth Avenue Southeast. Housing prices rise With only a few blips, U.S. housing prices have been increasing since 1942, with the most dramatic increase between 2000 and 2006. In January 2000, the median price of new homes sold in the United States was $163,500. In April 2006, it had climbed to $257,000. The most recent escalation came about after the Federal Reserve lowered interest rates to help the nation recover from the technology bust of 2000. Housing demand rose because mortgage rates were cheaper. Decatur housing prices rose sluggishly throughout the period, a fact that caused consternation at the time. That turned into a positive because there was no housing bubble in Decatur to burst, delaying the impact of the national economic crisis. Aggressive lending The lending system over time institutionalized its expectation of appreciating housing values. Banks knew they could collect on defaulted mortgages through foreclosures because the value of the home would be higher at the time of foreclosure than it was at the time of purchase. The soundness of real estate as an investment also contributed to legislation seeking to expand home ownership as an option to more Americans. The Community Reinvestment Act pushed banks to lend in neighborhoods previously "redlined" as high risk. Protected by rising home values, many lending institutions not subject to stringent banking regulations pushed subprime and adjustable-rate mortgages. The loans often required minimal down payments and minimal payments on principal after purchase, so purchasers acquired little equity in the homes for years. The increasing marketability of mortgages also contributed to aggressive lending practices. The lenders who performed the underwriting on a loan could sell the loan, thus isolating themselves from the risk of default. The distance between underwriting and collection became even more distant with the advent of collateralized debt obligation packages that included pieces of multiple mortgages. Investors with no connection to the home that backed the loan could pool their money and purchase packages of mortgages. These practices gave the originating lenders an incentive to make, and sell, as many loans as possible. Many lenders reduced their scrutiny of the borrower's ability to repay the loan and of the value of the home that backed the loan. The market for mortgage-backed securities became even more brisk in 2004, when the Securities Exchange Commission relaxed a rule requiring investment banks to keep cash reserves as a cushion in case of loss. That made more money available for the highly profitable -- and presumably safe -- mortgage securities. Some firms, including Lehman Brothers, borrowed up to $30 for every $1 in assets to gobble up more mortgage-backed securities. The popularity of insurance on the mortgage-backed securities -- such as the credit default swaps marketed by AIG -- also reduced the incentive for underwriting, and added to the number of companies relying on timely mortgage payments by homeowners. Bubble bursts In late 2005 and 2006, the housing bubble burst. Demand peaked, leaving a glut of houses on the market. Especially in overbuilt markets, prices plummeted. The drop in prices triggered some foreclosures, as speculators walked away from their now-sour investments. People who bought houses with the expectation of flipping them were stuck with a mortgage they could not pay. Foreclosures mounted because of the previous aggressive lending practices; even slight drops in income or increases in expenses -- most commonly fuel and food -- left borrowers unable to make their payments. As the number of foreclosures increased, the oversupply of housing increased, accelerating the downward spiral in housing prices. Mortgage collapse The combination of increasing foreclosures and decreasing home values was disastrous for banks and all those who held mortgage-backed securities. With mortgages routinely higher than the reduced value of the home, it became impossible for financial institutions to recoup their losses when borrowers defaulted. Companies like Countrywide Financial, Fannie Mae and Freddie Mac -- with direct exposure to the mortgage market and holding large numbers of high-risk loans -- were hit first. Lehman Brothers and Bear Stearns took early hits because they held massive portfolios of mortgage-backed securities. The losses damaged AIG because it was insuring the securities. Corporate collapse With losses rising, financial institutions needed to raise more capital. Selling the mortgage-backed securities was not an option because nobody trusted them. They had to take write-downs reflecting the huge drop in the market value of those securities, which reduced stock prices. Reduced stock prices limited their ability to raise capital through stock sales. Credit squeeze Scared of the housing market and having lost trust in mortgage-backed assets, financial firms began hoarding their money. The collapse of Lehman Brothers triggered mass withdrawals from money market funds, reducing further the money available for lending. Skittish depositors began pulling their funds. Banks stopped lending to each other, fearing more failures, and increasingly stopped lending to businesses. Where lending continued, it was at higher rates of interest. For lenders, panic has set in. The dollars they have they want to keep as a fragile economy makes all loans look suspect. Bailout The theory behind the main provisions of the bailout act is that cashing out the "toxic mortgages" -- especially the tainted mortgage-backed securities -- will permit lenders to regain trust in the solvency of borrowers. By purchasing the securities, the government hopes to unclog financial pipes so normal credit can resume. Unable to get banks to lend to businesses even when they have the cash to do so, the government has begun making direct, short-term loans to the businesses. Without access to credit, many companies cannot meet payroll or purchase raw materials. Production cannot continue. Another provision of the bailout bill allows the Treasury Department to buy equity in financial institutions. Such purchases not only inject capital into the banks, but give the government more control over the banks. That's critical, because then it can force a resumption of healthy lending practices. Decatur never had a housing bubble, so it is not suffering from a collapse in housing values. Foreclosures are up, but not nearly as much as in most parts of the nation. Wall Street looms over Decatur, however, because of the resulting credit freeze. Industries cannot produce without credit. If credit does not begin to flow, layoffs are next. By the numbers 29 The percent of houses, bought within last five years, with mortgages higher than their appraised values. $800 billion Amount Federal Reserve has put in financial system in last 14 months. The amount does not include the $700 billion bailout passed by Congress. 89 Percentage drop in Dow Jones Industrial Average from 1929 to 1932. 40 Percentage drop in Dow in last 12 months. To see more of The Decatur Daily, or to subscribe to the newspaper, go to http://www.decaturdaily.com Copyright (c) 2008, The Decatur Daily, Ala. 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