Audit Roundup: Don’t Forget Housing

NYT, WSJ on the rotting root of the crisis; Papers look at troubled hedge funds; etc.

The Times says the housing rout is far from over, with prices likely to decline for another year.

The current housing downturn is much more national in scope and severe than any other in the postwar period, partly because of the proliferation of risky lending practices. Today, foreclosures are running ahead of the downturn in the economy, a reversal of previous housing slumps.

“We are in uncharted waters,” said Brian A. Bethune, an economist at Global Insight, a research firm.

The paper doesn’t mention that many analysts think the financial crisis can’t really end until house prices find a bottom. The Journal yesterday noted that the Treasury’s bailout plan doesn’t really address the housing bust.

But some economists say the government needs to do more to address the underlying problems that triggered the credit crisis. “It’s very disappointing” that the plan doesn’t do anything “to stop the spiral in home prices,” which is reducing net worth and creating a falloff in consumer spending, says Harvard University economist Martin Feldstein. He proposes that the federal government offer low-interest loans to replace 20% of homeowners’ mortgages…

Falling prices are feeding a vicious cycle that leads to more mortgage delinquencies and foreclosures. As more Americans end up “under water,” or owing more on homes than they are currently worth, more people are likely to walk away from mortgages, causing foreclosures to rise further and adding to negative market psychology.

Today, the WSJ reports that FDIC head Sheila Bair is criticizing the Administration’s plan for not helping homeowners. Good for her:

“I support all the measures; I’ve been a part of all the measures that have been taken,” she said. “But we’re attacking it at the institution level as opposed to the borrower level, and it’s the borrowers defaulting. That is what’s causing the distress at the institution level. So why not tackle the borrower problem?”

The Times reported last year that Bair had tried to get the subprime industry to adopt better practices. It seems she has good intentions but just hasn’t been given the power by the Bush Administration to follow through.

The Times gives a lot of space to New York Attorney General Andrew Cuomo announcing he’s going after AIG to recover some executive bonuses it passed out—and compares the action to Eliot Spitzer’s back in the day. But this seems more like grandstanding, with an outdoors press conference on Wall Street, than something that will have any real effect.

Cuomo, after all, made a lot of noise about the ratings agencies, which were bad actors critical to creating this crisis, and then agreed to a settlement with them that contained no punishment.

The FT reports that hedge funds suffered more than $43 billion in withdrawals in the U.S. last month, something that has some hedgies—gasp!—offering to suspend their outrageously high fees until March if their investors just keep their money in them. Talk about “definancialization”:

A fundraiser for a major hedge fund said the period “between now and December 1 is a sort of death march” for the industry.

The chief executive of a leading alternative investment manager said he expected the hedge fund industry to shrink by 50 per cent in coming months — with half the decline coming from withdrawals and half coming from investment losses.

Since hedge funds are so levered with debt, every dollar of withdrawn money forces nearly three dollars of sales by the hedge fund, which helps drive down prices.

The Journal reports that one of the biggest hedge funds, Citadel, has been waylaid in the last month, losing some 30 percent of its value. It says a rumor posted on Tuesday that its results were much worse helped stoke fear that sent markets plunging yesterday by their most since Black Monday of 1987.

The Citadel rumors gained momentum as the Web site Dealbreaker published some of them.

The item was posted for about an hour on the site, but was taken down after a Citadel executive called. “We removed the Citadel post after it was brought to our attention that it was a baseless rumor, and was irresponsible to repeat,” Dealbreaker wrote on its site. The site had labeled it the item an “unfounded” rumor.

The Journal reports that the crisis is like whack-a-mole: knock it down one place and it pops back up in another.

Government efforts to heal the credit markets are having unintended consequences that are roiling different sectors of the market and adding to anxiety among investors, who already are worried about the impact of a possible recession on U.S. companies…

“You have unintended consequences that spark government actions, that create other unintended consequences,” said David Kotok, chairman at money managers Cumberland Advisors.

Bloomberg’s Jonathan Weil has a good column on how the banks are taking taxpayer’s money and still trying to conceal the true value of their balance sheets:

What investors need now is a good reason to believe corporate balance sheets. Otherwise, it won’t matter how much taxpayer money gets pumped into ailing financial institutions. We’ll still be risking systemic meltdown because nobody, especially the banks, will be able to trust anyone else’s books.

Yet that’s where the banking industry and its lobbyists keep taking us. They want government blessing to value their assets any way they want, using whatever numbers they desire. And the banks will fight to their deaths to get it.

Jesse Eisinger posts a good look in Portfolio at the advent of the credit-default swap.

Morgan’s derivatives project began in the wake of the Asian financial crisis in 1997 as an attempt to protect the bank from bad loans. Demchak’s innovations worked—for his bank. Morgan came to dominate this corner of the financial world while preserving a culture of prudence. Morgan—deemed to be so safe that it snagged two of the victims of the financial-system collapse, Bear Stearns and Washington Mutual—is still swimming in credit derivatives, far more than any other firm on Wall Street, though the bank says it’s hedged. As of the second quarter of 2008, the bank had written derivatives contracts backing credit valued at $10.2 trillion, roughly three-quarters the size of the U.S. economy.

But Demchak’s innovation has a more troubling legacy. J.P. Morgan, rather than being inoculated, was actually becoming the Patient Zero of Wall Street, eventually carrying the credit virus to the far corners of the global financial system. The structure of the first derivatives deal wasn’t as solid as Demchak’s team had intended. That initial, flawed financial instrument was later replicated thousands of times by J.P. Morgan and other banks, with the same defects repeated and magnified over and over again.

Has America ever needed a media watchdog more than now? Help us by joining CJR today.

Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at Follow him on Twitter at @ryanchittum.