Diatribune

Alex Wierbinski, Berkeley, Ca., August 17, 2007

This rather large reduction in interest rates has driven the market up considerably today, after a week of heavy losses.

Beneath all of this market instability are the homeowners, many of whom are holding on to the notion that their houses will maintain their bloated prices. Across from them is a diminishing group of buyers, determined not to buy at the top, so hold on for a long and wild ride.

The problem is complicated, so hang on. The problem started in mortgage securities backed by sub-prime loans, but has spread doubt about the value of all mortgage securities in the market.

The reason is that once the sub-primes failed, and sub-prime loans dried up, a significant part of the housing market disappeared. The sub-prime housing borrowers and lenders, ceased to operate. This immediately stopped the rise in housing values across the nation, independent of the type of loans used to fund purchasing.

The housing market was softening before the mortgage securities failures. The mortgage securities failures defined the top of the real estate market. Now we need to find the bottom.

This means that even prime borrowers are seeing the values of their recently purchased homes fall below the price they paid. This has caused defaults to spread from sub-prime mortgages to the holders of prime mortgages. The drop in housing values and the rise in defaults means that the actual value of existing mortgage securities consisting of both prime and sub-prime mortgages have dropped, and nobody knows what they are actually worth.

Although the Fed's cut in interest rates stimulated the equities market, it does not address the cause of the downturn, which lays in the real estate and loan markets. There are two factors which will eventually determine the value of mortgage securities, which will be the only way to stabilize Wall Street. The first, and most important, is the level of home sales prices and sales activity. The second factor is the amount of credit that will be available, and the rate of interest that will be charged for it, after the market accurately assesses and balances the assets and liabilities of the American economy.

The value of mortgage securities will only be determined when the real estate market stabilizes. This will only occur when housing foreclosures moderate, home loan rates stabilize, and the real estate market determines the real, sustainable, value of housing, and the the level of sales activity the market will support.

If the housing market continues to lose value, and sales continue to stagnate, the value of mortgage securities will continue to be uncertain, if not be under serious downward pressure. The credit crisis will deepen. If this occurs no amount of Fed interventions will prevent the various markets from falling precipitously.

If housing prices and sales remain relatively stable, the financial wizards of Wall Street will quietly comb through the mortgage securities, reevaluating this mass of debt significantly downward, to reflect the decline in housing values, the defaults, and the loss of expected future profits.

This loss of value will require that all borrowers who used mortgage backed securities as collateral for their loans come up with additional collateral to cover the loss. This is where the credit crisis deepens, as the collateral for past loans loses value, and the costs of future loans rise.

If housing continues to fall, as I expect it will, there is significant risk of a sustained global downturn in economic activity. Our valuation crisis has the potential damage global markets and bring down unstable foreign markets. Failures in Asia or South America could cause further credit problems here. The problem could ricochet around the world, causing a cascading failure of credit markets. But nobody knows.

This is where we are right now, between doubt and fear. Uncertainty and instability will characterize the markets until the real estate market stabilizes.

This is why the Fed's pumping the financial markets with cash, and dropping the interest rates are peripheral to the central problem, which is the uncertain value of real estate, and financial activities backed by real estate.

The Fed cannot stop the market from reevaluating housing, and consequently the value of all assets based on housing. This means we are experiencing a general reevaluation of American assets and liabilities. This reevaluation is reverberating around the all of world's interdependent markets.

The Fed's actions did one important thing: They infused confidence into the equity markets. The Fed clearly and firmly told the world that they are on the job and responding as necessary to stabilize American credit markets. But everybody knows the problem is in real estate.

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