Bailout failure throws banks into disarray

With mortgage-backed securities infecting the global credit system, banks around the world
are not only raising cash — they’re hoarding it to protect against the rising tide of losses they may face in the near future.  With widespread uncertainly about which banks will survive and which ones will go under, bankers are also fearful of lending money to another bank that may end up on the list of those that fail.

That slowdown in lending between banks is moving down the chain as banks hoard cash that their business customers need to fund day-to-day operations.

The cycle will be difficult to break until the markets see some indication that home prices are stabilizing. For that to happen, the rate of mortgage defaults and foreclosures will have to peak and begin to subside.

So far, the most problematic loans have been adjustable mortgages armed with low “teaser” rates to qualify borrowers into loans they couldn’t afford. After two- and three-year delays, defaults from those who couldn't afford payments when teaser rates ended are now working their way through the system,

But there is a more ominous problem with a class of loan that became popular at the tail end of the housing boom. These so-called "pay-option ARMS" allow homeowners to choose among different monthly payments. The complexity of these loans makes it difficult to forecast how many borrowers ultimately will default.

“That's the biggest problem out there right now, especially with the pay-option ARMs: how to value these (loans),” said Mark Hanson, a California-based mortgage consultant at the Field Check Group. “This is toxic not only for the bank's balance sheets but also the consumer balance sheets because the principle balance keeps rising on 80 percent of the people that don't make the fully indexed payment, until they get to a point where they just implode.”

It can take years for that implosion to happen. Analysts at several major Wall Street firms have estimated that — unless these toxic loans are defused in the next 18 months — these pay-option ARMs will begin imploding in 2010 and 2011. That would bring on another wave of foreclosures, just as defaults from ARMs with two- and three- year “resets” have begun to work their way through the system.

Those estimates could be made worse by continued rise in unemployment. Homeowners who might otherwise be able to afford their mortgages face a much tougher time when they lose a steady paycheck.

As banks work to mark down their debts and raise more capital, consumer households face the same painful transition. After years of easy credit, households are already finding loans harder to get. That means they, too, will have to try to raise cash and cut their existing debts.
One way they can do that is to cut spending.

On Monday, the government released fresh data showing that consumer spending stalled in August as the impact of the tax rebate stimulus plan began to fade.

"Consumers seem to have hit the foxholes," said Joel Naroff, president of Naroff Economic Advisors Inc. in Holland, Pennsylvania.

As the credit crisis spills over to the broader economy, a further slowdown in consumer spending would weigh even more heavily on the economy — about two-thirds of which relies on purchases of goods and services.

"It looks like we are poised to see a real-term decline in personal consumption and that will likely result in a negative GDP number in the third quarter," said James O'Sullivan, economist at UBS Securities in Stamford, Conn.

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