1:00PM New York – U.S. Treasury Secretary Paulson says that the slow-down in housing market is likely to have bigger than expected impact on the economy.

Secretary Henry M. Paulson said in prepared remarks delivered at Georgetown Law Center this morning that ongoing housing correction is likely to persist longer than anticipated a year ago.

For months the administration, the Federal Reserve Bank board members, and former Chairman Greenspan had said that the impact of the housing market slow-down is going to be limited. The severe underestimation of the nature of the problem was widely forecasted by the Fed, the current U.S. administration, and executives of the largest banks and financial brokerage companies.

In the last two months, total losses reported by banks and brokerages related to mortgage markets have totaled nearly $25 billion but several market analysts have now raised their estimates of losses between $350 billion and $400 billion.

In the speech, Paulson blamed the current crisis to the ‘abundant supply of easy credit’, speculation, and a decline in underwriting standards. He further added that “as demand for housing began to slow in 2004, originators, eager to maintain high mortgage origination volumes, further lowered their underwriting standards.”

At the time when the early correction in the housing market began as home values rose out of the reach of new buyers underwriters responded with interest only mortgages. The securitization of the mortgages also played a key part in funding the rising volumes of mortgages.

Paulson added in his comments that “The inevitable correction began in early 2006. Today, average nationwide home prices are barely up in the year through June, sales of existing single-family homes are down by nearly 25 percent from the peak in 2005, and the inventory of unsold homes has increased to levels last seen in the early 1990s.”

The sharp rise in subprime lending is has come to haunt the market. While new homes sales are down 40% from the peak of 2.4 million, they are still above the annual average of 1 million before the current began. The inventory of unsold homes is only adding the woes of the housing market. Also nearly 40% of mortgages sold in the coastal markets were classified as sub-prime mortgages. Defaults on these loans are rising.

Paulson expressed his concern on the rising foreclosure and said that “While the delinquency rate today is near the 2001 rate, there are over seven times more subprime mortgages today than there were in 2001. At the end of the second quarter of this year, more than 900,000 subprime loans were at least 30 days delinquent. Foreclosures are also up significantly – increasing about 50 percent from 2000 to 2006. Foreclosures on subprime loans are up over 200 percent in that same period. Current trends suggest there will be just over 1 million foreclosure starts this year - of which 620,000 are subprime.”

Alan Greenspan, former Chairman of the Fed, conducted an active campaign of caution during the dot com bubble, but failed to warn the markets of the consequences of historic low interest rates. The rapid rise in new home sales was regarded by the Fed as a sign of economic vigor and was heralded by the administration officials in the media. As recently as February 2007 several board members of the Fed suggested that the housing market problems are not expected to spread in the wider construction industry and never entertained the argument of its consequences to the wider economy. The historic low rates of 1% in five years ago fueled a boom in housing market and contributed to the significant rise in the housing market activities in the last five years. Neither the Fed nor the administration acknowledged the danger of extremely low interest rates. Chairman Greenspan only once suggested that normal markets do not work this way.

Paulson confirmed in the speech that “of the approximately 50 million outstanding mortgages in the U.S. today, approximately 10 million are subprime loans. Many have cited the statistic that 2 million of those subprime mortgages will reset to higher rates in the next 18 months. That statistic is true, relevant, and troubling, but it is not the complete picture of the risk going forward. Many of those borrowers will be able to afford their new mortgage payment or they will be able to refinance into another more affordable mortgage. Yet, the problem today is not limited to subprime mortgages as the number of homeowners having trouble making payments on prime mortgages is also increasing. And finally, the wide geographic variation in home price trends adds to the complexity of sizing this problem with any certainty.”

The speech also highlighted the recent slow-down in new home construction and sales. He added that “annual housing starts peaked at an annual rate of almost 2.3 million units in early 2006 before falling off more than 40 percent through August of this year. Employment in residential building, including specialty trade contractors, has dropped by almost 200,000 since early 2006, offsetting about one-quarter of the jobs gained in the housing boom. It looked like housing construction had reached a bottom in the first half of this year, but starts have declined again since June and data on permit applications and inventories of unsold homes suggest further declines lie ahead.”

Paulson showed a real sense of urgency in the speech and suggested that if immediate steps are not taken then the current problems of the housing industry are likely to spread in the wider economy. He said that “despite strong economic fundamentals, the housing decline is still unfolding and I view it as the most significant current risk to our economy. The longer housing prices remain stagnant or fall, the greater the penalty to our future economic growth.”

He favored an active approach in tackling the ongoing correction in the housing markets rather be a passive by stander. For moths the administration has promoted an argument that those who took the risk should suffer the consequences of their actions. He went to add that “When investors are relieved of the costs of bad decisions, they are more likely to repeat their mistakes. I have no interest in bailing out lenders or property speculators. Still, we must recognize the very real harms to families affected by the housing downturn. We must take steps to minimize the neighborhood effects and the macroeconomic effects of this housing market correction.”

Paulson also discussed the current set of steps that are taken by the administration, the President, and, the Congress. He highlighted various proposals that are currently in works including expanded role of FHA, tax relief proposal, and GSE reform to be passed Senate. He also favored reforming the regulatory framework and said that “Existing federal laws address mortgage fraud, disclosures, fair lending, unfair and deceptive practices, and other aspects of the mortgage process. But the regulatory and enforcement authority varies across different federal agencies. States have also enacted an additional layer of regulation, typically applied only to certain institutions that operate within that state and enforced by the state agencies. This patchwork structure should be streamlined and modernized.”
He went on to add that we need reforms and regulation in disclosure, origination, and predatory lending and liability areas.

Paulson also said that it is the regulated institutions and not the hedge funds are facing material exposure to the current housing market malaise. He highlighted that “The real irony is that the material problems arising in recent months were in regulated institutions in certain markets. Many regulated institutions, both in the U.S. and elsewhere, appear not to have fully appreciated all of the risks associated with the securitized assets on their balance sheets or the many risks associated with commitments to provide liquidity to off-balance sheet vehicles, such as conduits and structured investment vehicles.

Deteriorating subprime mortgage performance over the last several months led investors to question their assumptions about the credit quality and value of many assets. In July, as default rates surpassed their models' projections, ratings agencies downgraded billions of dollars worth of subprime mortgage backed securities.”

The speech highlighted the lasting nature of the current malaise. The administration has engaged to work with three large banks J P Morgan, Bank of America, and Citigroup. The current effort is focused on setting up a fund as large as $100 billion to facilitate the market functioning. While Wall Street expects a bailout from the government in the form of insurance on these losses it is still not clear what will be the involvement of the administration. Why does the U.S. administration that lectures the world on the benefits of the market based economies and free markets have to get involved when it comes to losses in the mortgage markets.

He added that “we must examine the role of credit rating agencies including transparency and potential conflicts of interest. We must also assess if regulations and supervisory policies are encouraging an over-reliance on ratings by financial institutions and investors. We must continue to address financial institution risk management and related regulatory issues. In particular, we must ensure that they adequately take into account the risks posed by protracted periods of market illiquidity or the risks posed by a reduced ability to securitize and sell loans, including leveraged syndicated loans and mortgages. Our bank regulators must evaluate regulatory capital requirements applicable to bank exposures to off-balance sheet vehicles. Transparency is important here, so we will also review the accounting rules that are applicable to off-balance sheet vehicles.”

The secretary also talked about the President’s Working Group involving the Fed, SEC, CFTC chaired by the Treasury to lead a comprehensive review into policy implications resulting from the current challenges in the credit markets. The steps suggested by the Secretary appear to be sound but individual investors wonder why it took so long for the Fed, the administration, and regulators to tackle the problems when the signs of failure in the housing markets were visible in the mortgage market in the years 2005 and 2006.