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10 Questions…on the Extended Reach of the Credit Crisis for Prakash
Dheeriya
In a
“10 Questions” that appeared in last year’s October issue of
The Report, Prakash Dheeriya,
professor of accounting and finance, warned of the impending credit
crisis sparked by a rash of sub-prime mortgage foreclosures. To say
he was right- on may be the understatement of 2007 as the credit
crisis could be considered the single largest news story of the
year. Yet as the firing of some top finance industry CEOs and a
softening of the entire U.S. economy suggests, the credit crisis has
had effects extending much further than the housing market. Here,
Dheeriya looks back and ahead to detail the reasons for the crisis’s
far-reaching impact and what he thinks is in store in the years to
come. Did you expect this to be as much of a national issue as it has become? No, certainly not. But this has gone beyond the issue of sub-prime mortgages. That’s where it started, but now, there are many other issues at play. This is affecting people holding regular mortgages as well as those who can no longer make their payments, and it has clearly affected the entire financial industry as the recent CEO firings suggest. How have dropping house prices affected people in regular home loans and their ability to meet their payments? Many people took out home equity lines of credit based on the rising value of their homes. The expectation was that the appraised value of their home would continue to rise and they’d be fine. But now, they’ve taken out loans on more than their homes are worth. So they have their mortgage plus this home equity loan. When combined, they’re upside-down on the value of their home, and as the general economy gets tighter, they find themselves unable to keep up with their payments. Is this the largest issue and implication of the credit crisis – people upside down with their traditional mortgage plus a home equity loan? No. The biggest issue now is the repackaging and reselling of securities, which are made up in part by loans that are now being defaulted upon. They’re called Structured Investment Vehicles (SIVs), which are a fancy, modified version of traditional Collateralized Debt Obligations (CDOs). That is one of the major underlying issue right now, besides the impending recession. Why are these repackaged securities the biggest issue? Because they’re made up of so many different parts, including some bad loans, and then sold and resold, it’s very difficult to put a value on these securities. So as the sub-prime crisis has become more widespread, the investors who own these securities – including some of the biggest banks and investment firms in the country – have been forced to make some major write offs for the losses and expected losses of these securities. For Merrill Lynch, it was something like $11 billion; for Citibank, the losses are still being counted, and their exposure can run up to $ 40 billion. Is Merrill and Citibank’s major losses from these securities at the heart of why their CEOs were fired? Yes, that and falling stock prices. It’s also why Goldman Sachs is riding so high – they saw this becoming an issue and sold off all of these SIVs before it became a major issue. Now, these securities are very difficult to value since most of the assumptions that they relied on are no longer valid. These firms are stuck with huge losses and that’s one of the major reasons how the sub-prime mortgage issue has moved into the rest of the economy. Isn’t there talk of either a government buy back or a number of banks getting together to buy back these securities to bail out these investors? Those plans are being discussed, but I think the fundamental issue is that these securities can’t be valued accurately. Even if the government or this consortium buys them back, either way, someone has to back them up. And at this point, I think many people are afraid of touching anything to do with housing. How long will it take for the housing market to rebound? I think the housing market will take at least a few more years to rebound. The problem is that it is cyclical. Lenders are tighter with whom they’re giving loans to, so buyers can’t get the loans to buy houses; houses continue to sit and their inventory keeps building up. Development and construction take a back seat. Until old inventory of houses disappears, prices will continue to fall. On top of all that, there’s a lack of confidence in the market. I expect we’ll see another round of foreclosures from the last of wave of the sub-primes issued from 2006. Their two-year terms will be up in 2008, and once the variable rates jump, the foreclosures will probably come. I think it will take a few years to sort itself out and I expect it will get worse before it improves. Where do you think we’ll see the housing market slow down the most across the country? I think it will continue to be more obvious in middle and lower income neighborhoods. The reason is that people who are more affluent can afford to sit on their homes for a longer period of time before selling. They can sit on an empty house, hoping to wait out the drop in house prices. What are some of the other implications of this credit crisis? Well, there are a number of things that could happen. I think a lot of real estate agents will have to find new careers. If I was looking to buy a house, I’d wait until about 2010 because I think the buyer’s market is going to continue to move more and more into their favor. I also think we might be on the cusp of a crisis for cities and other municipalities. They may have some serious issues providing the same services if they rely on property taxes to pay for things like water, sewer, etc. because as house prices continue to drop, people will have their homes reassessed so they don’t have to pay as much in property taxes. This obviously puts less in the municipality coffers, and thus affects their ability to provide the same services. Is there any way that things might improve in the short term? One interesting thing that might happen is that we might see the slowdown and the low value of the dollar attract foreign investors. That would certainly help matters to get things moving, but I’m not sure how likely it will be. The only drawback for them is that then they have to move here or rent out the properties because the dollar is unlikely to appreciate rapidly in the next year or two. |
