Housing bubble gigantic threat

While the country and the world are fixated on war with Iraq, little notice is being paid to a potential explosion that could eclipse any created by our new super-bomb.

That is the possible collapse of the real estate bubble that looms on the horizon. Residential mortgage debt has grown tremendously, from about 5 percent of non-financial debt following World War II, to 20 percent in the mid-1980s and to 30 percent by the end of 2001. It holds the potential for significant effects on the entire U.S. and global economy.

The government-sponsored, publicly traded companies that deal with much of this debt are: the Federal National Mortgage Association (Fannie Mae) created in 1938, the Government National Mortgage Association (Ginnie Mae), which became a private entity in 1968, and the Federal Home Loan Mortgage Corp. (FHLMC).

That’s where the tremendous boom comes in. The first two, Fannie Mae and Ginnie Mae, hold 45 percent of outstanding residential debt in the country. That’s $3.1 trillion, a huge leap from just 25 percent of the debt in 1990.

In a recent speech, William Poole, who heads the St. Louis Federal Reserve Bank, warned of the possibility of a serious crisis with these two government-chartered operations.

“Major unforeseen events that can bring about a collapse in confidence or disruption to the normal function of financial markets without any warning, can and do occur with some frequency,” Poole said.

He added: “Repercussions in the financial markets on 9-11 might have been much worse, had the Fed not demonstrated in 1987 that it could and would react immediately to major market disruptions.”

Poole noted that Fannie Mae and Freddie Mac have pools of capital well below the levels required of regulated depository institutions. The requirements call for these companies to have 2.5 percent of on balance assets and .45 percent of outstanding mortage-backed securities (MBS) and other obligations on hand.

Fannie Mae and Freddie Mac, while federally chartered, are not federally backed. Poole said an unexpected shock could create a crisis in U.S. markets.

There is evidence, he said, that an unexpected price shock—such as that resulting from a war—could cause losses in non-financial sectors that could affect total economic activity in the country.

A prime area of concern here is the brisk business in over-the-counter derivatives. Globally, the total amounted to $111 trillion in 2001, up from $80.3 trillion in 1998.

Outstanding contracts leaped from $3.2 trillion in 1998 to $3.8 trillion in 2001. The net value of these contracts is less than one-third the gross market value.

“It helps to make this issue concrete by listing some examples,” Poole said. “The failure or near-failure of Penn-Central, Continental-Illinois, Long-Term Capital, Enron and WorldCom may not have been complete surprises to knowledgeable insiders, but the shocks were certainly ‘news’ to market participants, regulators and the general public.”

A report issued by the Office of Federal Housing Enterprise Oversight points out that if commercial and private borrowing is used to buy assets in a market with a bubble, i.e., overvalued, a shock that bursts the bubble will amplify the effects.

If the market is one important to the economy, it could trigger a high level of borrower defaults and create a serious liquidity problem for banks and other financial institutions. The Japanese economy for the last 20 years is a classic example, and now the German economy is in trouble.

Here at home the government is using the magician’s ploy—watch the “showdown with Saddam”—don’t look at what my other hand is doing, just stay glassy-eyed in front of the boob tube, soaking up all the mythology we can hand you.

Of course, the government claims any such collapse as painted here is extremely remote because of various controls that have been put in place. Nonetheless, the possibility exists, and when the administration’s economic policies take full effect, the ball may bounce differently than anyone expected.

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