"It's Housing Stupid"

The Wall Street crisis has been caused by plunging housing prices. So despite the billions of dollars being thrown at the problem, experts say more trouble lies ahead.

By Chris Isidore, CNNMoney.com senior writer

September 17, 2008: 3:03 PM EDT

NEW YORK (CNNMoney.com) -- The nation's financial system is in the midst of a massive shakeup and many on Wall Street and in Washington are pointing fingers and looking for someone to blame.

But in the end, it all comes back to one issue - housing.

Earlier this decade, it was much easier to get a mortgage. Home prices soared about 85% from 1996 through 2006 in inflation-adjusted dollars, creating a bubble.

Then the bubble popped. And the fallout isn't over yet, experts say.

In the past two weeks, the government took over Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500), Lehman Brothers (LEH, Fortune 500) filed for bankruptcy and Merrill Lynch (MER, Fortune 500) sold itself to Bank of America (BAC, Fortune 500).

If all that weren't enough, the Federal Reserve announced late Tuesday night that it was loaning $85 billion to insurer American International Group (AIG, Fortune 500).

None of this would have happened if the housing market had not imploded, leaving all these firms with staggering losses from their investments tied to mortgages.

"These institutions, which weathered all kinds of calamities before, including depressions, are being knocked out," said Lakshman Achuthan, the managing director of the Economic Cycle Research Institute. "It's a testament to the significance of the problem we have here."

Thus, experts agree that there are likely to be future shocks to the financial system until the housing market finally hits bottom.

Even Treasury Secretary Henry Paulson, the administration's point man in the many rescue discussions of the past month, admits this.

"The housing correction poses the biggest risk to our economy," Paulson said the day he announced the Fannie and Freddie seizure. "Our economy and our markets will not recover until the bulk of this housing correction is behind us."

The problem of falling home prices

But because of the depth of the housing problems, it may take a long time before real estate prices head higher again. Here's why.

Home prices, while sharply off from the 2006 peaks, are still high in comparison to long-term gains in income, rents or overall prices, suggesting that they still have a way to fall, according to experts.

The reason housing is wreaking havoc even on insurers like AIG and big investment banks, who do not make mortgage loans, is that during the boom, trillions of dollars of mortgages were packaged together into securities that promised to pay investors with the proceeds of those loan payments.

Those securities paid better rates than other types of assets during the boom years. So many investors from around the globe poured as much money as they could into those securities.

Faced with this demand, lenders starting making more loans to riskier borrowers, including people who might not be able to afford their mortgage payments in the future and even many with no proof of income.

When prices were rising, this wasn't a problem. The risk of loan foreclosure or default was limited because many homeowners were able to sell their house for more than they owed and make a profit.

But once prices topped out and began falling, loan defaults and foreclosures started shooting higher as homeowners found it more difficult to sell their house. This created problems not just for subprime borrowers but even for those with good credit and income.

When foreclosures rose, the value of the various types of securities tied to mortgages started to fall, causing huge losses up and down Wall Street. It also made banks less eager to extend credit because of the risks involved.

A downward spiral

This credit crunch in of itself slowed the economy, leading to job losses and more defaults, feeding a downward spiral that has been difficult to stop.

"A really bad situation -- a home price bubble bursting -- was made significantly worse when the recession began," said Achuthan. "Now we have to let this thing play out."

Some experts even argue that the steps being taken to rescue firms like AIG could make a recovery in housing and the broader economy more difficult, as financial firms and investors become more reluctant to lend money.

"We are certainly taking credit and squeezing it tighter and tighter," said Kevin Giddis, managing director of investment bank Morgan Keegan. "Housing needs buyers. Buyers need credit."

Achuthan said that even though rates for mortgages and other types of loans have fallen in the last two weeks, those loans are becoming more difficult for many consumers and businesses to get because banks are severely tightening their lending standards.

And if housing prices do fall further, that will only cause more losses in the financial sector and perhaps more failures of banks, insurers and securities firms.

"I would hesitate to say the worst is behind us," Achuthan said.

So even with perhaps hundreds of billions of tax dollars going to AIG, Fannie and Freddie, one expert said the only real solution to the housing problem is for the correction in housing to finish running its course.

"We want home prices to return to normal," said Barry Ritholtz, CEO of Fusion IQ and author of the upcoming book "Bailout Nation."

"Until that happens, you can throw as much money at the market as you want at the situation....and it ain't going to make any difference," Ritholtz said.

AIG woes seen benefiting insurance rivals

With almost any rise and fall, someone is bound to benefit. Below is a great article by Reuters explaining just who that is in the case of AIG.

By Simon Challis

LONDON (Reuters) - Insurance rivals stand to reap the benefits from the woes of American International Group Inc, snapping up assets AIG is forced to sell, while gaining greater pricing power as AIG pulls in its claws.

Zurich Financial Services AG (ZFS) and other insurance rivals are possible winners, say analysts who see AIG emerging from its current troubles with less weight to throw around.

"The first consequence we see is that it should be a positive for the P&C (property and casualty) industry," said JP Morgan analysts in a research note.

"This effectively represents a withdrawal of capacity (or capital) from the marketplace ... Pricing in the P&C market is driven by capital -- the less capital, the less pressure there is for prices to fall."

The likely withdrawal of billions of dollars of AIG capital from the sector will put a brake on the slide in prices in the commercial insurance market, where premiums had been expected to fall by up to 20 percent due to intense competition.

AIG has long been a dominant player in corporate insurance, with an 11 percent share in the U.S. market, as well as for other big-ticket risks such as aviation.

Now, intermediaries predict that although AIG will continue underwriting, it is likely to lose business clients.

"In our view, ZFS is probably the clearest winner," said JP Morgan.
One senior executive at an insurance broker who spoke on condition of anonymity saw others benefiting as well. "Zurich and ACE Ltd are likely to be the beneficiaries, maybe even AXA SA. Anyone with a multinational network will be a winner," the executive said.

"It's still early days, but it's my view that AIG is a wounded animal. It will be hard for us to say to clients, 'We'll place your business with a company who we have no idea what its ownership or management structure will look like in six months' time,'" the broker added.

Among lines of business, insurers providing specialized commercial coverage, such as directors' and officers' liability, could pick up business as AIG scales back participation, said Goldman Sachs analyst Tom Cholnoky, in a note Tuesday.

He named Ace, Travelers Cos Inc and XL Capital Ltd among the biggest and likely beneficiaries.

However, reinsurers could be worse off, seeing less business if AIG's gross premium volumes decline, Cholnoky added.

Many of AIG's chief competitors would likely highlight their own credit ratings and financial stability as a major selling point in an effort to attract business that was belonged to AIG, Citigroup analyst Joshua Shanker said in a note Tuesday.

FIRE SALE?

AIG's rescue calls for the U.S. Federal Reserve to lend it up to $85 billion for two years in exchange for a 79.9 percent equity stake.

AIG will pay interest at a steep 8.5 percentage points above the three-month London Interbank Offered Rate, equal to about 11.4 percent. That gives AIG a big incentive to embark on a massive asset sale program to pay back the loan quickly.
Insurance rivals are set to jostle to pick up attractive parts of the AIG empire, including profitable aircraft leasing arm International Lease Finance Corp (ILFC).

AIG's stake in reinsurer Transatlantic Re, its market-leading operations in Central and Eastern Europe and Asia would also be enticing, analysts say.

Munich Re has registered its interest in picking up AIG assets, but it is likely to face stiff competition, with Japan's well-capitalized and acquisitive insurers and Australia's QBE also seen as potential bidders.

Analysts say Canadian life insurance company Manulife Financial Corp, the biggest in North America by market value, might consider acquiring AIG's U.S. variable annuity business. Manulife executives have said they would like to enter the Japanese and Chinese wealth-management markets.

"If you take out all the financial services business, AIG had a classic life and property/casualty insurance business, and it was very profitable. They made good money," said Thomas Noack, insurance analyst at WestLB.

"This ... represents an opportunity for those companies either with cash, or with access to cash (via leverage), to build out their portfolios," said JP Morgan.

"AIG has some attractive assets in our view. We are now undoubtedly in a buyer's market in our opinion, although we expect a lot of competition for the assets."

AIG in a Free Fall

CHARLOTTE, N.C. (AP) -- Shares of American International Group Inc. declined further Friday over continuing concerns about whether the world's largest insurer has adequate capital reserves.

Also dogging the stock were worries over the soundness of Lehman Brothers Holdings Inc. (LEH, Fortune 500) as financial stocks also saw declines.

AIG (AIG, Fortune 500) plummeted $5.41, or 31%, to $12.14 by the time the market closed, its lowest point in 15 years.

Worries about AIG's financial position intensified after being hit hard by deterioration in the credit markets amid worries that complex, structured investments it insures will increasingly default.

Citi Investment Research analyst Joshua Shanker on Friday lowered his price target on the insurer to $25.50 from $40 to reflect current market conditions.

"Marketplace fear of financial institution collapse is rampant," Shanker wrote in a note to clients. "This is causing severe anxiety over the financial condition of AIG, whose stock is under pressure." The stock has lost nearly 50% of its value in the past week alone.

Credit-ratings agency Standard & Poor's Ratings Services put ratings of AIG on CreditWatch with negative implications, saying the action follows a "significant" decline in AIG's share price and an increase in credit spreads on the company's debt.

Investors remain concerned about whether AIG has adequate capital reserves. Some on Wall Street have called for AIG, which operates a wide range of businesses across 130 countries, to break up its substantial assets, either through sales or by creating third-party investment vehicles.

Over the past three quarters, AIG has lost about $25 billion in the value of credit default swaps - or default protection for bondholders - and about $15 billion on other investments.

Executives say they believe actual, realized losses will end up being much smaller.

Since the company reported earnings on Aug. 6, the stock has fallen 58%.

"We believe that AIG has sufficient capital and liquidity to meet its policy obligations and potential collateral requirements, which are significantly greater than the expected cash losses on the mortgage-related assets," said S&P credit analyst Rodney Clark. "However, additional market value losses will place some strain on the company's resources."

S&P said that after discussions with executives, the agency could affirm the current ratings or lower them by one to three notches.

The New York-based insurer is currently rated "AA-."

Late Thursday, attorneys for a Louisiana pension fund reached a $115 million settlement in a shareholder lawsuit against former executives of the New York-based insurance giant.

The settlement was reached just days before a trial was to begin in a lawsuit challenging hundreds of millions of dollars in commissions paid by AIG to C.V. Starr & Co., a privately held affiliate controlled by former AIG Chairman Maurice "Hank" Greenberg and other AIG directors.

C'Mon Ike, relax will ya?

13 of 26 Texas refineries, producing about 3.6 million barrels of fuel a day, are shut down as they brace for Hurricane Ike's impact.

By Aaron Smith and Kenneth Musante, CNNMoney.com staff writers

Nearly a quarter of U.S. fuel production had been shut down due to the approach of Hurricane Ike, according to a government assessment released Friday.

By 10:00 A.M. ET, 13 of the 26 Texas refineries, representing a production capacity of 3.6 million barrels of fuel a day, had been shut down, the Energy Department said.

Texas accounts for more than a quarter of the nation's total capacity to produce gasoline and other petroleum fuels. In normal operation, facilities there can produce up to 4.8 million barrels a day, according to the government.

Most of the Texas refineries are located along the ports of Houston, Port Arthur, and Corpus Christi, where Ike is scheduled to make landfall Friday night or Saturday.

Refining facilities on land are more vulnerable to flooding and power outages than offshore facilities, according to Ray Carbone, president of oil trading company Paramount Options.

"Without power, no refineries will be working and the flooding could complicate how long it takes them to come back online," said Carbone.

"Close to 20% of the U.S. refining capability could be lost for a long period of time," wrote Jim Rouiller, Senior Energy Meteorologist at Planalytics in an email. "Major and long term damage likely at the major refining cities from Galveston and Texas City northward to Baytown," he wrote.

After Katrina, some refineries were shut down for 6 to 9 months, according to Tom Kloza, chief oil analyst for Oil Price Information Service.

All Texas ports from Freeport west to Louisiana were closed Friday as well, according to the Energy Department.

Much of the nation's Gulf infrastructure had already been shut down or operating at minimal capacity due to Hurricane Gustav, which struck over Labor Day weekend.

However refineries in Louisiana that had been shut down due to the previous storm were in the process of re-starting or were already operating, the Energy Department said.

The refinery shutdowns drove up gas prices in the region.

Gas prices edged up nationwide by a fraction of a cent on Friday, to an average of $3.675 per gallon from $3.671 the prior day, according to the motorist group AAA. But in Houston, the increase was more dramatic, with the average gas price jumping more than 4 cents to $3.496.

Pipelines: All of the major crude and natural gas pipelines flowing out of the region had been completely or partially shut, the report said. The approach of Ike has caused many pipelines to declare "force majeure," which frees them from delivery obligations in case the worst happens.

The 20 of the 38 natural gas pipelines in Ike's path were confirmed shut down by the Energy Department at 12:00 p.m. ET, reducing capacity by 10.5 billion cubic feet per day. The shutdowns include facilities already in stand-by mode as a result of Hurricane Gustav.

The government also shut down Strategic Petroleum Reserve sites at Bryan Mound and Big Hill, Texas, and West Hackberry, La.

Offshore rigs: Evacuations also continued from oil rigs and platforms in the Gulf of Mexico, and from parts of coastal Texas, including Galveston and parts of Houston.

In the most recent figures available, the Minerals Management Service reported on Thursday that 562, or more than 78%, of the 717 manned production platforms in the Gulf had been evacuated, along with 93 of the 121 rigs.

But the real-time figure is likely higher, as all companies in the Gulf reported on Thursday that evacuations were either underway or completed. Many of the facilities were in the process of being restarted after Hurricane Gustav.

Some companies, such as BP (BP) and Chevron (CVX, Fortune 500), reported on Thursday that all evacuations of offshore facilities had been completed.

Chevron spokesman Mickey Driver said all 3,000 employees and contractors had been pulled out of the Gulf, where the company operates about 700 production facilities, including 400 manned platforms. It was still operating some unmanned facilities remotely.

ConocoPhillips (COP, Fortune 500) on Thursday had pulled all workers from its offshore Magnolia platform.