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Easy Money, Lifeblood Of Economy, Is Drying Up

By Tomoeh Murakami Tse and Dina ElBoghdady
Washington Post Staff Writers
Thursday, July 26, 2007

NEW YORK, July 25 -- In just a few days, shares of Internet travel company Expedia lost 12 percent of their value, one of the highest-flying executives on Wall Street watched his fortune shrink and the nation's largest mortgage lender said many Americans with good credit were in danger of losing their homes.

At the root of those seemingly unrelated events is a single new reality, one that could portend trouble for the broader U.S. economy: The era of cheap money appears to be ending.

Easy credit has been the economy's lifeblood in recent years. It gave people who previously couldn't afford homes a crack at the American dream. It fueled multibillion-dollar takeovers of some of corporate America's biggest names. It buoyed the stock market and propped up the prices of many other assets.

But now, the investors who a few months ago were willing to lend money to Wall Street at low interest rates, on loose terms, are balking as they worry about having to pay the price for lax lending standards.

The trouble started in one of the shakiest sectors of finance, home mortgages for people with bad credit, but it is spreading. As easy credit dries up, some huge corporate deals are being delayed and could unravel.

The question now is how far will the pain spread, and how many people will get hurt as it does.

"When people get scared, they tighten up all over," said A. Gary Shilling, president of the investment firm that bears his name. He said he expects housing prices to fall significantly further. "This kills consumer spending," he said of the credit crunch. "We think we'll be in a recession as a result by the end of the year. And that will spread globally because U.S. consumers still are the buyers of first and last resort for the excess goods and services produced around the world."

Yesterday, Chrysler postponed a $12 billion debt offering connected to its pending sale because of poor market conditions, according to people familiar with the matter. Separately, British health and beauty chain Alliance Boots, the target of what would be Europe's largest debt-financed buyout ever, postponed its debt sale.

It has been common for companies to borrow money to finance stock buybacks, but this week Expedia had trouble getting favorable loans to do that and had to sharply reduce a planned repurchase. The travel company's share price has fallen 12 percent since.

Those at the top of Wall Street's earnings pyramid are feeling the pinch. Stephen A. Schwarzman, co-founder of private-equity giant Blackstone Group, has seen the value of his multibillion-dollar stake in the company shrink since it went public last month. Yesterday, shares of Blackstone closed at $25.51, well below its initial offering price of $31.

Some market watchers say the credit market is simply in a midsummer pause, and investors will return to scoop up the billions of dollars in loans and bonds yet to be sold.

"What's really going to trigger the rally is when people start to refocus on the strong fundamentals in the underlying economy as well as the companies that issue the high-yield bonds," said J. Eric Misenheimer, a fund manager at J. & W. Seligman. "Default rates are still very low. Corporate earnings are robust and their balance sheets are some of the strongest they have seen since the mid-'90s."

But regulators and analysts say it is becoming clear that the housing downturn and problems in the related mortgage market will be more prolonged and uglier than they had thought. That has investors worried about rising defaults on risky mortgages infecting the credit market, and in turn, dragging down the economy.

With home prices falling in many parts of the country, millions of subprime borrowers, those with shaky credit histories, are falling behind on their payments and losing their homes. In many cases, their homes are worth less than their loan balances, and with prices down, they cannot sell or refinance their way out of trouble.

This has caused a drop in the value of securities and bonds backed by the loans. During the housing boom, lenders issued loans in record amounts, often on very loose terms. Wall Street financial firms bought huge pools of the loans, repackaged them as bonds called mortgage-backed securities, and sold them to hedge funds and other investors.

Since 2000, more than $1.8 trillion worth of securities backed by subprime mortgages have been created, according to Inside Mortgage Finance.

Hedge funds made money off those securities by turning them into complex investment vehicles called derivatives and selling them to pension funds, insurance companies, foreign investors and others. The rise of such financial partners empowered the lending industry to sell even-riskier loans.

The failure of several highprofile hedge funds has highlighted how quickly things can turn. This month, two Bear Stearns hedge funds -- valued at $20 billion this spring -- told clients that their investments were worth pennies on the dollar, if that. The funds contained subprime-backed securities.

While many policymakers said problems would be limited to the riskiest borrowers, it appears that the more creditworthy prime borrowers also are struggling.

This week, Countrywide Financial, the nation's largest mortgage lender, said there were more borrowers with good credit falling behind on their home-equity loans.

That shook the markets because of Countrywide's size and its reputation as a shrewd lender. The thinking was that if Countrywide saw trouble spreading, "the problems are likely to spread even more," said David A. Hendler, senior analyst at CreditSights, a securities research firm.

Weakness in the housing market "will get materially more severe," Richard F. Syron, chairman and chief executive of Freddie Mac, said yesterday. The government-sponsored mortgage-funding company based in McLean holds about $712 billion of mortgage-related investments.

Freddie Mac is relatively insulated from the subprime segment of the mortgage market, but it has funded unconventional loans such as those on which borrowers pay only interest for a time instead of paying down the principal. At the margins, problems have been creeping from the weaker segments of the market into the stronger ones, Syron said.

"Housing prices will go down," he said. The result will not be "catastrophic," he said, "but it will have a measurable impact on how people spend money. It will have a material impact on how people spend on cars, how they spend on consumer appliances, how they spend on lots of things."

Federal Reserve Chairman Ben S. Bernanke told Congress last week that investors' and lenders' losses flowing from subprime credit problems are estimated to be $50 billion to $100 billion so far. But he also sought to allay concerns about widening credit risks, noting that "financing activity in the bond and business loan markets has remained fairly brisk."

Bernanke gave no reason to think that the problems in the housing and credit markets were bad enough to prompt a cut in the Fed's benchmark short-term interest rate, which has held steady for more than a year at 5.25 percent. He said the Fed was more concerned about inflation than the risk of weaker growth.

ElBoghdady reported from Washington. Staff writers Nell Henderson and David Hilzenrath in Washington contributed to this report.

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