The Housing Nightmare Hits Main Street

One domino toppling the next. It's been a convenient metaphor for how troubles in the American subprime mortgage market have cascaded into a global financial mess. Rising interest rates collapsed the housing bubble, which caused a wave of subprime mortgage defaults and foreclosures. That, in turn, froze corporate credit markets as risk-averse investors stopped buying esoteric mortgage-backed securities and led to big losses at bond insurers. Auction-rate securities--an obscure corner of the credit market used by hospitals, museums, schools, and local governments--have been the most recent dominoes to tumble. "We've gotten to the point of almost paralysis in some segments of the market," says David Resler, chief economist at Nomura Securities.

A daisy chain of financial disaster, you might say. One crisis begetting another. Yet at least there's been a certain linear, if ruthless, logic to it all. But now there are signs that the housing recession is turning into a full-fledged economic meltdown in what the Federal Reserve recently called an "adverse feedback loop."

Put simply, this means a tightening of credit across the spectrum--from mortgages to credit cards to auto and student loans--that robs consumers of their confidence, further constricting credit and stopping the economy in its tracks. Result: a full-blown recession as nasty as Americans have seen in a generation.

Is it inevitable? No, but as seen in last week's Case-Shiller report that home prices dropped 8.9 percent last year, time is running out. That is why the Fed, the Bush administration, and Congress are working overtime on stimulus plans, government bailouts, and other pump-priming measures to loosen the noose around the economy. The next step, already underway, is to limit foreclosures, thereby stabilizing home prices. The two headaches are hardly mutually exclusive: Just ask Syreeta Dorsey, a 31-year-old insurance underwriter who paid $255,000 for a single-family bungalow on the South Side of Chicago last August. But shortly after she moved in, plumbing and heating problems led to costly repair bills, putting Dorsey behind on her mortgage payments. Now she faces foreclosure, and since her property is worth less than her mortgage, Dorsey is unable to escape the situation by selling her home. "The only thing that can save me right now is a prayer," Dorsey says.

Should her home go into foreclosure, as now appears likely, Dorsey's hardships will seep into the broader community, as prices of nearby properties also take a hit. Mark Zandi, chief economist at Moody's Economy.com, estimates that every foreclosed home lowers the value of all homes on its block by nearly 1.5 percent.

To arrest that trend, Senate Democratsrecently introduced legislation to support housingcounseling, alter bankruptcy rules to allow judges to modify mortgages, and provide $4 billion for certain local governments to purchase foreclosed homes. But as the scope of the problem widens--home repossessions nearly doubled in January from the year-earlier period--far bolder measures are being pursued as well.

Following FDR. Think of them as a New Deal for the 21st century. Sen. Christopher Dodd and Rep. Barney Frank--who head the finance committees of their respective houses--have suggested that the government gobble up troubled loans at a discount and swap them for more-affordable, fixed-rate mortgages. Dodd's plan is fashioned after the Home Owners' Loan Corp., an agency President Franklin Roosevelt established in 1933 during the Great Depression. Given the agency's success in absorbing a similar wave of foreclosures, broad-based support for its reincarnation has been building.

Former Fed Vice Chairman Alan Blinder says that without such an agency, "you have the prospect in the next year to two years of 1 million to 2 million homes being dumped onto the market." Blinder figures a new HOLC might require the government to risk between $200billion and $400 billion. While he would expect the agency to be profitable, a loss of even $30 billion is "chicken feed" compared with the program's potential benefits, Blinder says.

Central governments have a rich history of stepping in during periods of extreme financial turmoil. Just weeks ago, the United Kingdom moved to nationalize Northern Rock, a struggling bank. And the feds jumped into the U.S. savings and loan maelstrom of the late 1980s, taking control of hundreds of bankrupt institutions.

But taxpayer-funded government bailouts are always controversial. While the Treasury Department is open to new proposals, "we're not interested in transferring risk from Wall Street banks onto the backs of U.S. taxpayers," says Jennifer Zuccarelli, a department spokeswoman. Former Treas-ury Secretary Lawrence Summers opposes government intervention at this point, citing "issues of equity ... having to do with people who borrowed responsibly and rewarding people who borrowed irresponsibly." Dean Baker, codirector of the Center for Economic and Policy Research, suggests temporarily changing the foreclosure laws to give homeowners the option to stay in their homes as renters paying the fair-market rent. "This policy would not bail out the banks and doesn't cost the taxpayer a penny," Baker argues.

Others, like market strategist Edward Yardeni, say the Fed--which has acted quickly to cut rates--is still in the best position to stem the housing market's decline. And while he's pleased with the central bank's moves to reduce the federal funds rate from 5.25 to 3 percent so far, Yardeni says rates need to go even lower. "A 2 percent Fed funds rate could go a long way to stabilizing home prices," he says.

But in an election year, it would be naive to expect Congress to twiddle its thumbs as Americans lose their homes by the hundreds of thousands. Alex Pollock of the American Enterprise Institute is "virtually certain" that lawmakers will act--it's only a question of what they will do. And to ensure that government intervention is effective, Pollock suggests that policymakers study the lessons of the HOLC.

Ultimately, it's a confidence game. Overexuberance on Wall Street and, yes, Main Street got the country into the mess as M.B.A.'s and everyday folks forgot the adage that what goes up must come down. But if the markets and Washington can work quickly enough, the damage to the economy might just be stanched in time.

By Luke Mullins