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checkrates.com Mortgages Article, Teeing Up the Next Mortgage Bust

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In responding to the subprime mortgage crisis, most Congressional Republicans and many Bush administration officials apparently believe they have time on their side. They are wrong.

The housing bust is feeding on itself: price declines provoke foreclosures, which provoke more price declines. And the problem is not limited to subprime mortgages. There is an entirely different category of risky loans whose impact has yet to be felt — loans made to creditworthy borrowers but with tricky terms and interest rates that will start climbing next year.

The fits and starts are harmful. The housing bust is in the downward spiral of price declines and foreclosures. Single-family-home prices dropped 7.6 percent from the first quarter of 2007 through the first quarter of 2008, the largest year-over-year decline since the National Association of Realtors began reporting prices in 1982. Conservatively estimated, 2.2 million homes will enter foreclosure this year. An additional nine million homeowners — those with zero or negative equity — are considered at high risk of default because they have no cushion if recession or inflation, or both, make it impossible for them to keep current on their mortgages.

Theoretically, when prices fall, consumer demand should rise, sending prices back up again. Unquestioning belief in that self-correcting mechanism is the reason many Republicans don’t want to do anything to prevent foreclosures.

But in many cities today, house-price declines are so severe that potential buyers are staying on the sidelines, fearful of further collapse. The result is declines that are deeper than need be to restore affordability. That’s everyone’s problem, because as long as house prices continue to fall, the financial system will remain unsettled and the economy will not revive.

And if house prices fall more than expected — a peak-to-trough decline of 20 percent to 25 percent is the rough consensus, with the low point in mid-2009 — financial losses and economic pain could extend well into 2011.

That is because a category of risky adjustable-rate loans — dubbed Alt-A, for alternative to grade-A prime loans — is scheduled to reset to higher payments starting in 2009, with losses mounting into 2010 and 2011. Distinct from subprime loans, Alt-A loans were made to generally creditworthy borrowers, but often without verification of income or assets and on tricky terms, including the option to pay only the interest due each month. Some loans allow borrowers to pay even less than the interest due monthly, and add the unpaid portion to the loan balance. Every payment increases the amount owed.

In coming years, if price declines are in line with expectations, Alt-A losses are projected to total about $150 billion, an amount the financial system could probably absorb. But until investors are sure that price declines will hew to the consensus, the financial system will not regain a sure footing. And if declines are worse than expected, losses will also be worse and the turmoil in the financial system will resume.

There’s a way to avert that calamity. It’s called foreclosure prevention. There is no excuse for delay.

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