Bloody and Bloodier

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Bloody and Bloodier
The subprime-lending crisis is worse than you think, and could crush financial and real-estate markets for years.

* By James J. Cramer


(Photo: Illustration by Brett Ryder)

You’re losing money right now. This very minute. You’re losing money if you own an apartment. You’re losing money if you own a country home. You’re losing money if you own a stock or bond mutual fund. You’re losing money if you have a pension plan. You’re probably losing money here or there, you’re probably losing money everywhere (except maybe from your savings account and wallet). But this is no Dr. Seuss story. It’s more of a John Steinbeck tale, and we are the victims, a new generation of Tom Joads, and it’s the damn bankermen who broke us. No, there won’t be a police officer to investigate, and the government, at least this federal government, won’t save us.

Our tale of woe starts not in New York but in flashy places like Las Vegas and South Beach and faraway onetime Okie haunts like Riverside, San Bernardino, and Ontario, California. In these towns, and dozens more like them, housing companies erected colossal communities of homes. Eager homebuyers and speculators fought each other for these properties, armed with cheap financing, courtesy of Alan Greenspan, who wanted to boost an economy reeling from 9/11 and create a legacy of homeownership for all, including those who could not document steady income or, for that matter, citizenship.

We think of him as Saint Alan now, but in a few years he will be known as the reckless Fed chairman who encouraged the creation and use of exotic mortgages that required you to put down very little money, odd creations like the “2 and 28,” an adjustable mortgage with low interest payments the first two years that explode into gargantuan fees for the next 28. Don’t have the money to pay for the 2 before the 28? Go “piggybacking”: Take out a home-equity loan against your new house to meet those minimal payments.

Where did the money come from? Banks lent it, mortgage brokers lent it, and even home builders themselves got into the act. The housing markets were so hot the lenders barely had time to check if their buyers were deadbeats, cheats, speculators, or actual honest-to-Betsy hardworking people who wanted nothing more than what Tom Joad wanted 70 years ago. Oh, and the buyers didn’t have time to check out the terms, either; the value of the houses was going up too fast. Gotta close now! Nor did the regulators tap the brakes—whoops, there were no regulators. If something went wrong, who cares? The buyers could always sell their ever-appreciating home to the next guy on the reservation list or the ten after him. The builders, brokers, and bankers then shipped these mortgages east to the big Wall Street firms, which bundled them together and merchandised them as high-yielding bonds often backed up by nothing more than the full faith and credit of, well, no one.

Over and over, Greenspan hailed these fabulous financial breakthroughs that gave everyone a chance at the American Dream (or multiple dreams, in the case of speculators who took down homes and flipped them). And why not? Don’t homes always increase in value? Won’t there always be willing buyers armed with ARMs?

Except that wasn’t how it went down. The same guy who prescribed the mortgage elixir for all Americans then laced it with seventeen straight interest-rate increases, increases that brought rates to levels so high that legions of people who bought a home with a teaser rate couldn’t afford the payments. Between 2004 and 2006, just as interest rates started spiking and homes kept being churned out in these saturated areas, 14 million families purchased houses, many taking advantage of teasers and piggybacks. Given that the average home went for about $250,000, that’s hundreds of billions in loans that cost a lot more per month than when they were taken. Now these people are stuck. They can’t refinance because the rates are too high, and they can’t sell their homes to repay their mortgage, either. In every area of this country—and in particular, in the once-hot markets like the ones I mentioned earlier—there are just too many other homes for sale and too many new homes still being pumped out.

What do the woes of these folks have to do with you? Can a housing fire sale in Phoenix or Fort Myers really affect your Hamptons beach house or your newly purchased Upper West Side classic six? Well, yes, and in even bigger ways than you might think. That’s because the people who ultimately bought the bonds backed by what now look to be billions in bogus mortgages are those who run most of the big pension-, hedge-, and stock-and-bond-market mutual funds in this country. These suckers bought such bonds because bonds backed by mortgage-payment streams paid a tiny bit more than United States Treasuries, a comparable low-risk, if low-return, vehicle, and were supposed to have very little or no risk themselves. Some managers, however, borrowed huge sums to buy tons of these mortgages to turbocharge their results. And the most aggressive managers bought billions in mortgages given to less creditworthy individuals, the so-called subprime loans you keep hearing about.

Even though these loans have been losing value for years, it wasn’t until June 2007 that any of this mattered. That’s because of what is known in the trade as the “marks,” the value of a stock or bond as it’s “marked” by a firm. You are getting poorer by the second because many of these mortgage bonds were priced way too high because nobody thought that large numbers of borrowers would ever walk away from their homes rather than pay the interest that backed the bonds. Such a disaster had happened only once, in the thirties, and that was before loans were federally secured. The buyers and sellers accounted for the bonds as if they were as reliable as cash, because as long as employment was robust—and it is—they thought they would be fine.

But now all hell’s broken loose on Wall Street because of those mismarks. This spring, as many homeowners stopped paying, the mortgage bonds—for the first time—starting losing value. Hundreds of billions in bonds that were thought to be worth more or less the price they were sold at, it turns out, are worthless. That’s triggered a chain reaction: Brokers like JPMorgan, Goldman Sachs, and Merrill Lynch that lent money to the firms that bought the bogus loans—most famously, Bear Stearns—basically foreclosed on those firms to get their cash back. But the firms, which are always running full tilt, didn’t have the money to pay up. Bear, at the direction of the now-fired former co-president Warren Spector, let one fund just go down the drain. But Spector thought the other was still worth a great deal, so he put up $1.3 billion to pay back what the fund owed to the lenders and take direct control of the mortgage bonds. Spector, maybe one of the best minds in the bond business, genuinely believed that these mortgage-backed bonds still had substantial value. If someone as savvy as Spector thought these bonds were still good when they were actually worthless, that tells you that thousands of other managers are simply dreaming if they think their portfolios are worth anything near what they claim they’re worth. In other words, we’re looking at the start, not the end, of the lending meltdown.

Now these funds, which were supposed to be brimming with cash—the “liquidity” you hear about all of the time—turn out to have not much at all, and there are virtually no buyers anywhere for these mortgage-backed bonds, because who knows if the mortgages that are in them are worth anything? We only know that each day they are worth less than the day before, because every week, thousands of borrowers are being foreclosed.

Seven million people could lose their homes. New York, where the architects of card houses live, will feel the full force of the storm.

Here’s another layer: The panicked managers of these firms were supposed to be the buyers for all of the high-yielding corporate bonds being issued to pay for the private-equity deals of Cerberus, KKR, Blackstone, and other private-equity firms. They were supposed to lap up the paper for all of the leveraged deals that are in the hopper for underperforming companies like Tribune Corporation and Chrysler. The Goldmans and JPMorgans had already promised the money to the Blackstones and KKRs. They are on the hook—“hung,” to use the grisly vernacular—but they can’t sell the bonds to their usual pension-, hedge-, and mutual-fund clients because those clients don’t have anywhere near the money they thought they had and are facing redemptions from furious investors. Now, pretty much every large financial institution in the country is caught in a web it can’t get out of. Bogus mortgage paper is infecting the system, and no one has a cure.

Which brings us back to your money and why you’re losing it. Unless you keep your money in cash or Treasuries or CDs or the First National Bank of Sealy, there’s a pretty good chance that you’re in a fund or funds that are mismarked and worth less than they and you think. If you own a home, you’re in the financial crosshairs, too. It’s not just that the lending crisis is causing interest rates to rise, jacking up your monthly nut if you have an ARM. It’s that the value of your home is endangered because of the hit Wall Street—the industry, if not the stock market—is set to take.

In the past half-dozen years, the major brokerages in New York added hundreds of thousands of jobs in three areas: mortgage-bond sales and trading, private equity, and prime brokerage (the management of hedge funds’ brokerage accounts). Each has grown by leaps and bounds each year. Now all three are frozen. There are no mortgages to package and sell and no clients who want them. The private-equity deals are all hung. And the way I see it, the hedge-fund business is liable to be cut in half by the chain of mismarking and redemptions. I think that many of these firms have as many as 30 percent more people than they need right now in these departments, and all of them will be cashiered by the end of the year. The lists are being drawn up; the HR people notified. Not too close to the holidays, please! And for those who are left, sorry, no bonuses. The money was all eaten up by severances. Unlike other times on Wall Street, the jobs will dry up across the board, because so many firms have beefed up the same divisions. This time, get laid off at Bear, no walking across the street to Lehman. The departed will be cut off from billions in disposable income that fuel the New York economy.

What can thaw this nuclear winter? What can cause these markets to defrost fast enough to save the jobs, and home values, of the rich in New York, if not the newly poor and evicted in Rancho Cucamonga? Spooked by the news that major foreign banks are now getting hit by the lending crunch, investors took stocks down sharply last week, prompting Fed chairman Ben Bernanke to order up a quick injection of liquidity into the system on Friday. I think the Fed will also cut interest rates soon—certainly sooner than it otherwise would have. That said, this Fed has been famously inflation-wary, and it may be reluctant to loosen rates too much, lest it overheat the economy, especially since the Fed seems to believe that the nonfinancial economy, the part not connected with home building or lending, is thriving. Of the 30 stocks in the Dow Jones Industrial Average, only two, Citigroup and JPMorgan, are directly connected to this mess. If Bernanke’s right, and the rest of the economy is as solid as he seems to think it is, it’s possible the lending crisis could be contained to only those who work in and around the credit business. But that’s a big if. If the lending debacle keeps spreading, or the rest of the economy heads south, the Fed may find itself too far behind the curve to do much good.

Who else can unlock the jam? Maybe we get some help from overseas, a Chinese buyer of a major brokerage, perhaps? A Middle Eastern purchase of some of a big bank’s equity—Washington Mutual, maybe?—wouldn’t hurt. That’s what saved Citigroup in 1990. Perhaps Warren Buffett can come in and buy a Bear Stearns; hey, he saved Salomon in a different decade. What we need is some deep, untorn pockets to step up and buy some of the good paper that is being thrown away with the bad, so the trading desks can catch their breath and stabilize themselves. Giant losses would still happen, but perhaps not institution-threatening ones.

In other times, you might expect a president or a Treasury secretary to get involved, perhaps to pressure Fannie Mae, the organization set up in the thirties to issue emergency loans to alleviate just the kind of homeowning credit squeeze that we have right now, to lend a hand. But this administration seems to be either totally clueless or totally heartless, or both, and doesn’t want to goad Fannie Mae into helping. Maybe they hate that quasi-governmental institution set up by bleeding-heart Democrats to help struggling home buyers of a different, more liberal and compassionate, era. Or maybe they just think that anything short of an FDR-era Agricultural Adjustment Act for homes, where we bulldoze whole housing projects instead of cornfields to get price stability, just won’t work.

I fear that the pain and contractions in the housing and credit markets could cause as many as 7 million homeowners who bought houses in the past few years to flee or be tossed from their dwellings, even if the rest of the stock market thrives. It’s why I went off the reservation and screamed about this problem on television the other day (my latest unhinged rant). I see what could go wrong. I see how the forgotten man gets forgotten, and I feel helpless because I don’t see anyone doing a whole hell of a lot about it.

Thousands of miles from where the walls began tumbling down, New York, the town where the architects of card houses live, will soon feel the full force of the storm. So much of our economy depends on these financial builders and their minions who buy and sell the products that the pain may actually end up being felt worse here than in the epicenters of the problem. You just don’t know it or feel it yet. It’s all happened too fast, in just a few weeks of another sweltering summer, with the worst, much worse, yet to come. Which is why I bet that in the time it took for you to read this article, the Tom Joad effect just took another few bucks out of your pocket. Get ready, many more dollars will soon vanish before you discover you’ve been robbed.

James J. Cramer is co-founder of TheStreet.com. He often buys and sells securities that are the subject of his columns and articles, both before and after they are published, and the positions he takes may change at any time. E-mail: jjcletters@thestreet.com.