Is the Housing Panic Overdone?

Before addressing Wall Street's lobbying for rate cuts and housing bailouts, let's turn to New Orleans for another failure of government nerve, providing money but not sensible steps to reduce vulnerability.

One of the least reported and most consequential political statements of recent years was New Orleans Mayor Ray Nagin's "I have confidence that our citizens can decide intelligently for themselves where they want to rebuild, once presented with the facts."

That was March 2006. Mr. Nagin was running for re-election and his solomonic "rebuild at your own risk" was meant to shield him from charges that he was giving up on low-lying parts of the city occupied (at least in legend) by the poor, working class and black. Tens of billions in federal aid later, an Associated Press round-up last week cited Tulane geographer Richard Campanella to the effect that "time, weather patterns and the insurance market will prove the folly of allowing people to reoccupy the city's old footprint."

What's true of New Orleans is true of the entire gulf coast, increasingly a government subsidized set of bowling pins in the path of inevitable hurricanes.

But this year's Katrina is the housing market, in what seems to be an annual "crisis" that requires heroic federal exertions to relieve Americans of the consequences of their own choices.

Now let it be said that some serious and impressive people -- Harvard's Martin Feldstein, John Makin of the American Enterprise Institute, various Wall Street forecasters -- see deep economic repercussions from a complex credit crunch arising from the subprime lending mess. Fed Chairman Ben Bernanke appears to have become a believer after problems in the market for short-term corporate debt.

Yet it's also the case that the Fed's first mission is protecting its political independence. The Bush administration has already started compromising with the political furies, calling for tax changes and federal subsidies to help troubled borrowers. This may turn out to be a downpayment on a rescue operation unjustified by the current "crisis."

True there's always danger of self-fulfilling prophecy, but it's interesting to note the endless use of words like "toxic," "worthless," etc. for lower-rated mortgage paper that, however untradeable at the moment, continues to perform. Though defaults and foreclosures will happen, the hair-pulling in some accounts overlooks the fact that these are collateralized obligations. Investors may lose some money, but they won't lose all.

A related paranoia is that somehow the business of clearing won't occur, because homeowners can't find the lenders with whom to work out. If that were true, the lenders wouldn't be able to find the homeowners on whom to foreclose. Not only will investors have every incentive to minimize their losses, but workouts are often their best alternative.

The loss of a home a person can't afford through foreclosure can be anything from a tragedy to an inconvenience to a blessing, though the press can be relied upon to focus on the widowed grandmother, not the housing speculators who account for 25% or more of foreclosures in hardest-hit states. And what about the half a million people who lost their homes in, say, 2004 without Washington lifting a finger? As Katrina and 9/11 showed, it pays to be in the wrong place at the wrong time -- at the right time. That is, when cable TV will plump 24 hours a day for government action on your behalf.

Officialdom may believe its periodic bouts of activism have kept the ungovernable global markets from blowing up the real economy, but those markets arguably have performed better than government. Katrina was the most anticipated disaster in history, but neither the federal nor local government ever had any stomach for letting realistic price signals instruct homeowners and developers about the wisdom of living and building in locales that could not be protected from devastating weather.

You'll know Washington is doing for housing what it did for New Orleans if it now heeds countless pleas to expand the mandate of Fannie Mae and Freddie Mac to refloat the housing market and refinance underwater loans. Their lending already has grown much faster than the economy, much faster than housing demand, channeling a current $1.5 trillion in artificially cheapened capital into the housing market.

Fannie's and Freddie's securities were the direct conveyor recycling Chinese surpluses into U.S. housing -- with Washington supplying a de facto guarantee against Chinese losses. To imagine this wasn't a cause of home price inflation, and in turn subprime lending, is not to listen closely enough. Angelo Mozilo, CEO of troubled mortgage originator Countrywide Financial, knows his customers: "The main driver was real-estate values rising. And when they begin to rise -- no different from the tech boom -- everybody at all levels of society wants to participate. They don't want to be left behind."

For a longer-term perspective on the same phenomenon, consider that today's uptick in the foreclosure rate is nothing compared to the nine-fold increase that began in the 1960s and accelerated in the prosperous 1980s and 1990s. Other factors played a role, but always-available, government-backed financing has clearly helped make homeowners more willing to gamble their homes as a tax-favored wealth accumulation strategy.

Sadly, a few economists who see today's troubles as reason to curb Fannie and Freddie won't get much hearing in Washington. Our basic path to prosperity survived every other media-denominated "crisis" of recent years and will likely survive the U.S. housing correction (and the stock market is a powerful, non-panicky indicator here). Whether our prosperity can continue to survive the government's palliatives for all these upsets is another question.

Payback

Bailout has been a busy word in the last two weeks. But lending so solvent institutions won't go under for lack of short-term liquidity is very different than bailing out insolvent institutions from their bad decisions. In any case, we've made peace with a financial system that lives a little closer to the edge on liquidity than it would if there weren't a Federal Reserve. Whether the alternative would be a more stable world, with as much growth, is uncertain. But there's no doubt that the system has been conditioned to expect a general subsidy to risktaking by way of the Fed's willingness to provide cheap money in an emergency.

Everybody talks about moral hazard. A wisp of memory came to mind last week. Then-Fannie Mae chief Franklin Raines visited The Journal years ago and entertained himself by mocking editorial writers who assume that establishing that a policy is economically inefficient is enough to establish that it's unwise.

He yukked it up quite a bit, in fact, noting that voters are perfectly entitled to assert values other than those of the market, namely that homeownership is a social blessing and should be encouraged with subsidies. And so we've done with tax subsidies, lending subsidies and a concerted set of policies by Bill Clinton's HUD to move low-income people out of rental units and into homes they own. His goal, which was achieved, was to lift the homeownership rate from 64.2% to 67.5% of households.

But a home financed by a mortgage is not just an asset. It's also a liability. We owe thanks to Carolina Katz Reid, then a graduate student at University of Washington, for a 2004 study of what she dubbed the "low income homeownership boom." She considered a simple question -- "whether or not low-income households benefit from owning a home." Her discoveries are bracing:

Of low-income households from a nationally representative sample who became homeowners between 1977 and 1993, fully 36% returned to renting in two years, and 53% in five years. Suggesting their sojourn among the homeowning was not a happy one, few returned to homeownership in later years.

Even among those who held on to their homes for 10 years, the average price-appreciation gain was 30% -- less than if their money had been invested in Treasury bills. This meager capital gain was about half that enjoyed by middle-income homeowners.

A typical low-income household might spend half the family income on mortgage costs, leaving less money for a rainy day or investing in education. Their less-marketable homes apparently also tended to tie them down, making them less likely to relocate for a job. Ms. Reid's counterintuitive discovery was that higher-income households were "twice as likely to move long distance if they're unemployed."

Almost needless to add, the great squarer of circles for middle-income homeowners, the mortgage-interest deduction, won't turn a house into a paying proposition for those with little income to shelter.

Bottom line: Homeownership likely has had an exceedingly poor payoff for millions of low-income purchasers, perhaps even blighting the prospects of what might otherwise be upwardly mobile families.

And yet subprime lending wouldn't be a business without a flow of customers, and politicians and a vast array of interest groups flog the notion that owning a home is the American dream for anyone who can squeeze sideways through the door. Now this curse is being repaid with interest, and by an inherently unpredictable route -- don't buy any "news analysis" that says that because subprime lenders were known to be making risky or fraudulent loans, last week's credit meltdown in unrelated markets from here to Tokyo should have been foreseen.

Yes, you can find a hedge fund manager somewhere who bet on a credit crunch, just as you can find some who did the opposite. For every buyer there's a seller and selective evidence always supports the hindsight fallacy. That's more comfortable than acknowledging that big, unpredictable effects sometimes result from small causes.

The irony is, were the owners of the subprime paper inclined to make themselves known and realize their losses, the majority of these loans would likely end up paying off. Buyers of the severely discounted paper would make a killing and the market's dispersed decision-making, which recently became its weakness, would return to its normal role as a strength. In any case, subprime lending accounts only for about 15% of outstanding mortgages, with an uncataclysmic $90 billion worth facing foreclosure.

Fluctuations in the S&P 500 wipe out as much wealth every ho-hum day without drying up credit globally. But today's caginess problem is partly a regulatory and legal problem, because something is clearly stopping holders of temporarily unmarketable mortgage paper from sidling up to their bankers and asking forbearance on the loans financing these positions. The Fed's announcement of an accommodating discount window last Friday was an invitation to banks to help their clients dig out of these problems. But the Fed can't make them do so. If prosecutors and class-action lawyers now decide to launch an undiscriminating war on the mortgage finance industry, look out below.

For the sake of people trying to climb into the middle class, let's hope that one lesson will be a rethinking of policies designed to saddle them with money pits. The Democratic presidential contenders are currently outbidding each other in ways to help "homeowners" (a dubious term in the present instance) avoid foreclosure. What might really benefit these citizens is being freed to return to renting, where some real bargains will likely be had in the months and years ahead.

How Subprime Mess
Ensnared German Bank;
I

DÜSSELDORF, Germany -- Five years ago, a little-known bank that lent to small and midsize German companies decided it wanted to broaden its business. An affiliate of the bank started buying complex bonds invented in the U.S.

The strategy brought a sharply higher industry profile for IKB Deutsche Industriebank AG. Moody's Investors Service endorsed its move, crediting the bank last year with "successfully diversifying."

Today, IKB is on the receiving end of a bailout, organized over a weekend of emergency meetings by Germany's financial regulator, with contributions from major German banks. To rally the banks, the lead regulator warned that they needed to head off the risk of what could become the country's worst financial crisis since the 1930s. The safety net for IKB consists of about €3.5 billion, or $4.789 billion, available now to cover possible losses, plus a further financial backstop of €14.6 billion to keep afloat IKB and the affiliate that invested in fixed-income securities.

The case shows how quickly global investors' abrupt new appreciation of credit risk can ricochet around the world. As some strapped homeowners in the U.S. fail to make their monthly mortgage payments, among those touched by their defaults are institutions in Europe that borrowed to buy bonds backed by the mortgages. Their troubles, in turn, affected others in the market and injected worry into markets for even some safe securities.

IKB is housed in a seven-story stone-clad building a short distance from the Rhine. Since its founding 83 years ago, its main business has been to provide long-term financing to the smaller German companies called the Mittelstand -- companies like Trumpf Group, a maker of machine tools.

The affiliate IKB set up for bond investing five years ago is Rhineland Funding Capital Corp. The purchases included bonds backed by subprime mortgages, those issued to home buyers with weak credit. It was a global circuit: Rhineland partly funded its bond purchases through short-term debt issued to U.S. investors, such as a suburban Minneapolis school district and the city of Oakland, Calif.

But Rhineland's short-term borrowings had to be renewed frequently. And when investors realized that their collateral for the borrowings included U.S. subprime mortgages, they shut off the spigot. Suddenly, Rhineland couldn't repay other debt that was coming due. If other German banks hadn't agreed to bail it out a week and a half ago, Fitch Ratings believes IKB "would have defaulted," says a Fitch credit analyst in Frankfurt, Sabine Bauer. IKB is using bailout funds to repay the short-term borrowings, which are known as commercial paper.

Credit Problem

This wasn't the only U.S.-related credit problem to surface in Europe yesterday. The big French bank BNP Paribas SA suspended withdrawals from three investment funds, citing volatility in the U.S. asset-backed-securities market. That led to a scramble for cash. Short-term money-market interest rates spiked above their target levels in both Europe and the U.S. In response, the European Central Bank, in an extraordinary step, injected €94.8 billion in short-term funds into the system to get rates back down. The U.S. Federal Reserve injected $24 billion through its Open Market operations.
[IKB]

The crisis at IKB unfolded quickly. As recently as July 20, the German bank told investors it was fine. But days later, it began having trouble selling commercial paper.

That instrument is a staple of money-market funds and other risk-averse investors, regarded as one of the safest investments apart from U.S. Treasurys. It's often issued by big companies that use the proceeds for day-to-day expenses. But even the haven of commercial paper has been rattled in recent weeks, as investors began to worry about securities that might be tied in some way to subprime mortgages.

Rhineland's difficulty in issuing new commercial paper didn't go unnoticed by Deutsche Bank AG, one of several banks that helped Rhineland sell the paper. Deutsche Bank tipped off Germany's financial watchdog, called BaFin. Within 48 hours, the banks and regulators had structured a bailout package.

Three of IKB's top executives, including Chief Executive Stefan Ortseifen, departed. The bank formed a task force to sort out its problems. Its stock is down 33% since the crisis began to develop about two weeks ago. Mr. Ortseifen declined to comment.

Tax Haven

IKB dreamed up Rhineland in 2002 as a way to move beyond its German client base of smaller companies. IKB set up Rhineland in Delaware and Jersey, a tiny tax haven in the English Channel, so it could borrow from investors in the U.S. and Europe.

Rhineland poured the proceeds into a highly rated portfolio of bonds. Seeking high yields, it often invested in bonds or bundles of bonds backed by other securities, including subprime mortgages. According to people familiar with IKB, it was courted by banks such as Lehman Brothers Holdings Inc., J.P. Morgan Chase & Co. and Deutsche Bank AG, which sought to sell it securities including collateralized debt obligations. Known as CDOs, these are pools of debt broken into tranches, or slices, that offer investors various levels of yield and risk.

IKB was such a good customer that banks would adjust which assets they bundled together in CDOs on IKB's wishes. For example, IKB's risk team didn't like airplane loans, so banks would often remove them. The banks declined to comment.

Rhineland's profit was the difference between what it had to pay for its commercial-paper borrowings and the return on the bonds it bought with the proceeds. On its commercial paper, Rhineland had to pay approximately the London interbank offered rate, or Libor, a common benchmark. The bonds it bought returned about a full percentage point above Libor. IKB is just one of many banks that set up companies to use this strategy. They're usually off-balance-sheet so that banks don't have to set aside capital to cover the liabilities.

To sell its paper, Rhineland often looked to U.S. investors. Robbinsdale Area Schools district in a northwestern suburb of Minneapolis bought some last year, thus lending money to Rhineland. It did so on the advice of a Citigroup Inc. broker in St. Paul, says Gary Hauan, director of finance. Citigroup declined to comment.

'We Don't Take Risks'

Oakland, Calif., also bought some of the paper, figuring that the collateral-backed debt was safe. "We don't take risks," says Katano Kasaine, the city's treasury manager. Also buying Rhineland commercial paper was the Montana Board of Investments, which manages a $13.2 billion fund.

All three say they won't be buying any more of this issuer's commercial paper. They shouldn't have to worry about what they did buy, despite IKB's troubles, because its affiliate can repay the paper with proceeds of the IKB bailout. The Montana board, however, is looking through the rest of its commercial-paper holdings to see if any others are tied to CDOs, says its executive director, Carroll South.

IKB, started in 1924, helped Germany rebound from the decimation of World War II by lending to companies rebuilding. But in 2002, when German bank profits were hurt by an economic slowdown, ratings agencies pressured the country's banks to diversify away from lending to companies.

A trio of IKB officials came up with the idea for Rhineland, led by a banker and lawyer named Dirk Röthig. He joined IKB in 2001, bringing with him experience working with bonds in Europe for the U.S. bank State Street Corp. Alongside him was a longtime IKB official, Winfried Reinke.

The venture was a success. IKB's fledgling asset-management arm earned fees for selecting Rhineland's investments. IKB bought similar bonds for Rhineland and its own portfolios, according to IKB's annual report.

Paying Commissions

In the fiscal year ended March 31, IKB earned just under €180 million, with €108 million of that coming from fees and commissions. Rhineland paid roughly half of the commissions, according to IKB's annual report.

The bank and other banks established a line of credit -- to be tapped only in the most drastic of situations -- promising to cover liabilities if Rhineland couldn't pay off the commercial paper.

Rhineland grew quickly. In September 2003, it held €4.8 billion of debt. By January 2006, it had €9 billion.

Its commercial-paper program, led by Deutsche Bank, won an award in 2003 from Banker Magazine. In 2004, Mr. Röthig told industry publication Risk magazine, "This adventurous portfolio building was the outcome of a carefully planned strategy. We wanted to diversify in asset classes as well as geographically because we were pretty much dependent on the German economy." The next year, at an investment conference in Barcelona, Spain, Mr. Röthig sat alongside executives from banking heavyweights -- France's Société Générale SA and Dresdner Bank AG -- on a panel on how to pick investments in U.S. asset-backed and mortgage backed-securities.

Fast Expansion

But executives at Rhineland disagreed about how fast to expand. In January 2006, Mr. Röthig left after others overruled his objection to growing so quickly, he said. "I made several proposals for a more sophisticated portfolio management to address expected negative market developments," which weren't accepted by IKB, he said in a statement. IBK declined to comment.

Growth accelerated after he left. Between then and this July, Rhineland boosted its assets -- that is, the bonds and other debt it had purchased -- to €14 billion from €9 billion. That was a large investment in view of IKB's stock-market value, which was just a bit over €2.6 billion at the end of this March.

Home-Equity Loans

A December 2006 report by Moody's credited IKB for its success and noted, "IKB has over the last few years been successfully diversifying its business activities by expanding outside Germany." Earlier this year, IKB founded another Rhineland-type vehicle, called Rhinebridge, to invest in bonds backed by U.S. home-equity loans.

By February, though, U.S. subprime mortgages written in 2005 and 2006 were showing increasing delinquencies, as home prices weakened and some borrowers' mortgage rates adjusted higher. As defaults rose, the value of securities backed by those mortgages began to tumble.

In a financial update July 20, IKB said it wasn't incurring problems. It acknowledged that both Moody's and Standard & Poor's had downgraded some debt securities but said, "It is worth noticing that the bulk of our investments are in portfolios of corporate loans."

But Rhineland's commercial-paper investors were getting jittery, as they saw erosion in the value of the bonds backing their investments. Even if the company wanted to sell bonds to pay off creditors, it would have a tough time finding buyers, some worried. About a week after IKB's financial report, the bank started having difficulty finding buyers for additional commercial paper. At SEI Investments Co. in Oaks, Pa., Sean Simko, head of fixed-income asset management, says his firm stopped buying Rhineland paper last month because of growing volatility.

By Friday, July 27, IKB was in trouble. Some of the commercial paper was maturing, and investors needed to be repaid. But buyers for new commercial paper had vanished. It couldn't sell CDO assets to raise funds, because the market for CDOs had dried up.

Rhineland was going to turn to IKB, Deutsche Bank AG and others that had promised a credit line to pay its bills in an emergency. That strategy had its own pitfalls. If they provided Rhineland with the money, Rhineland's bills would move to IKB's modest balance sheet, a scenario that could topple the bank.

Even worse, the banks, including Deutsche Bank, that had standing agreements to lend IKB money backed out. Deutsche Bank declined to comment.

Instead, Deutsche Bank, Germany's biggest bank, phoned BaFin, the German financial supervisory agency, to tell it there was a problem with IKB, people familiar with the matter say.

State-Owned Shareholder

That same day, according to a person familiar with the matter, IKB's management board reported the problems to the bank's biggest shareholder: KfW Group, which is state-owned.

BaFin called for a special probe of IKB's books. Over the last weekend in July, it convened a crisis meeting at IKB's Düsseldorf headquarters near the Rhine River. Representatives from KfW, BaFin and IKB met in the large auditorium of IKB's headquarters.

On Sunday, July 29, executives from Germany's banks as well as regulators began meeting at IKB as well. BaFin repeated that it wanted to prevent panic selling of IKB shares when the markets opened the next morning. Joining Jochen Sanio, the BaFin chief, were Joerg Asmussen, a department head at the German finance ministry, and Ingrid Matthaeus-Maier, head of KfW. From his office at Deutsche Bank's headquarters in Frankfurt, CEO Josef Ackermann participated by phone, along with Klaus-Peter Mueller, chief of German bank Commerzbank AG.

One CEO was missing. IKB's Mr. Ortseifen had agreed to resign.

KfW's Ms. Matthaeus-Maier said the extent of the assets at risk was unclear. Other executives disagreed over the structure and size of the rescue deal. Negotiations dragged on late Sunday night, as BaFin's Mr. Sanio grew impatient.

Rescue Package

They finally settled on a plan for KfW, the state-owned institution, to shoulder most of the rescue package. The rest would come from other German banks, the Association of German banks, and other associations. IKB got a new chief executive: Günther Bräunig, an executive of KfW.

The next day, stock markets reopened, and IKB's shares tumbled 20%.

IKB hasn't yet decided what to do with the Rhineland portfolio of bonds and CDOs. An IKB spokesman, asked about the bank's statement July 20 that it didn't face any trouble, said it was an "attempt to calm fears. Nobody anticipated that the market for commercial paper would develop in such a way."

Moody's analysts, meanwhile, are monitoring small and midsize European banks, looking for other subprime stress, according to a report the firm published after the IKB bailout. Like IKB, Moody's analysts wrote, some of these smaller banks in Europe have boosted profits in recent years the way IKB did, by creating off-balance-sheet affiliates.