BBC NEWS | Business | Debt City Shows U.S. Housing Woe

The United States has experienced an unprecedented spike in construction and real estate prices

The city of Stockton, California is at the center of the mortgage crisis currently sweeping America.

Because, with falling house prices, more people in Stockton are facing home repossession than anywhere else in the United States.

But Stockton is also a place where you can really get a sense of the staggering amounts of money lent by banks during the boom – with little to no questions asked.

Lending Frenzy

In his 25 years as a real estate agent in Stockton, Kevin Moran had never seen anything like this as seemingly unlimited bank loans sent property prices skyrocketing.

US real estate agents have seen the market move quickly

“It was crazy,” he says. “People thought that if they didn’t bid a house high enough, it would disappear.

“Instead of saying ‘What do you want to do on a Saturday? Let’s go to the park’, they were saying ‘Let’s go buy a house'”.

At the height of the buying frenzy, in 2006, Will Trawick was selling new homes for a Stockton developer.

In front of a crowd of a hundred buyers, bank loans in hand, all chasing the 20 houses he could offer, he organizes bingo-style lotteries.

“We had ping pong balls with numbers on them, like you would see on a TV show,” Mr Trawick recalls.

“Everyone would have a number. We would put in the ping pong balls, spin them around and, you know, ‘Number 22! Yoo-hoo!’ They were jumping and shouting, coming and choosing the house they wanted and leaving a deposit check”.

Banks weren’t the only ones willing to lend.

With property prices soaring, almost everyone who owned a home in Stockton suddenly found they had a lot of equity in their property – equity that banks were eager to convert into cash.

Mr Carrigan says easy loans have seen consumers spend their homes

Steve Carrigan is in charge of Stockton’s economic development. He says bank loans have made it a party every day.

“People went to the bank and got a loan on the increase in the price of their house. They went out and spent all that money,” he explains.

“The price of the house went up again, they went back to the bank and got another loan. They went back and spent that money on cars, jewelry and furniture – whatever they wanted.”

With the help of the banks, Mr Carrigan says, the people of Stockton “spent their house”.

But that’s not how it should be.

Dodging the rules

After previous financial disasters caused by excessive bank lending, regulators developed rules to limit the number of loans a bank could have on its balance sheet.

The rules are complex, but as a general rule they say that for every $1 (50 pence) of share capital a bank has on its balance sheet, it can also have around $10 in loans.

But, as the torrent of home loans in Stockton and across America clearly shows, the banks were lending far more than that 10 to 1 ratio.

How had they managed to do it?

Professor Roubini says banks have bent industry rules

The first technique used by banks to circumvent regulators’ rules is known as “securitisation” – a way for a bank to obtain loans it had already made on its balance sheet.

They did this by selling their loans to pension funds, insurance companies, and even other banks around the world.

Professor Nouriel Roubini, director of a leading New York economic analyst firm, says securitization was key to helping banks avoid regulators’ 10:1 rule.

“You do a bunch of mortgages and then package them up and sell them to someone else,” he explains.

“Therefore, it disappears from the books and so you can do even more loans.”

As a result, the amount of loans banks could make was “much more massive”, he says.

Financial Alchemy

The loans from the banks should have been a tough sell because they were of poor quality – since they were issued without questions being asked, there was little assurance that they could be repaid.

But the banks had an answer to that.

To make their risky loans attractive to buyers, the banks used complex financial engineering to repackage them so that they looked super safe and paid returns well above what equivalent super safe investments offered.

Even Wall Street veterans were surprised by debt securities

Even savvy Wall Street veteran and billionaire Wilbur Ross couldn’t figure out what was going on.

“What they were basically doing was taking a $100 stack of low-quality stocks and creating something that they could sell to investors for $103,” he says.

“So there was chemistry – making more price than there was value.”

Banks have even found ways to remove loans from their balance sheets without selling them at all.

They designed bizarre new financial entities — called Special Investment Vehicles, or SIVs — in which loans could technically and legally be held off-balance sheet, out of sight and outside the scope of regulators’ rules.

So, once again, SIVs have made room on balance sheets for banks to keep lending.

Final countdown

As long as real estate prices kept rising, few people wondered about the potential risks of bank-created structures.

Everyone was making too much money to worry about.

But then, in 2007, when US house prices began to fall, the real dangers began to be revealed.

If you have a loss of 200 billion dollars, which reduced your capital by 200 billion dollars, you must reduce your loans by 10 times more Professor Nouriel Roubini

Banks had circumvented regulators’ rules by selling off their subprime loans, but because so many of the securitized loans were being bought by other banks, the losses were still inside the banking system.

Loans held in SIVs were technically off banks’ balance sheets, but when the value of loans inside SIVs began to plummet, the banks that created them found that they were still responsible for them.

So, investment losses that might have appeared outside the scope of regulators’ 10:1 rule suddenly started showing up on bank balance sheets.

No one knows how big the losses from US mortgage-based investments will be – estimates now range from $200 billion upwards.

The problem now facing many of the largest lenders is that when losses appear on banks’ balance sheets, the regulator’s 10:1 rule comes back into play as losses reduce banks’ shareholder capital.

2008 pain

Prof Roubini says that even at the low end of the estimates, the potential impact on the rest of the economy is huge.

“If you have a loss of $200 billion, which has reduced your equity by $200 billion, you need to reduce your loans by 10 times that much,” he explains.

“So you could have a reduction in total credit to the economy of two trillion dollars.”

The professor predicts that a credit cut on this scale will trigger a recession in America that could become global as the contagion spreads through the global banking system.

This is why, faced with these gaping and growing holes in the capital of their shareholders, some of the largest American banks are selling shares to China, Singapore or the oil-rich Gulf States, in an attempt to repair the damage.

Some U.S. politicians are already complaining about such sell-offs but, for all of us, we better hope that the banks’ ultimate strategy will succeed in averting at least some of the likely pain to come in 2008.

You can hear Michael Robinson’s special series Threat of debt – the monster that stalks the global economy on BBC World Service on Monday 31 December and Monday 7 January at 0905 GMT.