Memo to Obama: Welcome to Hard Times

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Given the reality of a credit crunch that shows few signs of easing despite the billions of dollars of government money thrown its way, an alternative to offering the new president-elect congratulations might be: “Welcome to hard times.”

The honeymoon period that most new presidents enjoy has probably been voided this time around. From Day One, as the former Democratic presidential candidate, Sen. Hillary Rodham Clinton used to say, President Barack Obama will face a financial crisis that only threatens to become more severe at the start of 2009. And it’s one for which there are no simple fixes — only controversial and painful remedies that may or may not work.

Illustration by: Matt Mahurin

“It’s really analogous to choosing a new skipper for the Titanic after it already hit the iceberg,” said Guy Cecala, publisher of Inside Mortgage Finance, which covers the subprime lending industry. “It’s not the kind of situation where the president can sit down and and concentrate on a plan. He’ll be in damage-control mode every single day.”

The first big problem: The subprime mortgage mess that has led to so many foreclosures already is only about three-quarters of the way through, Cecala said. Foreclosures overall set a new record — with a 71 percent jump in the third quarter of this year, according to RealtyTrac. But more are coming, and soon, as subprime loans with adjustable rates reset this month and in 2009, hiking monthly payments as much as 40 percent.

The Center for Responsible Lending predicts some 2.2 million subprime foreclosures in late 2008 and through the end of 2009.

As bad as that sounds, subprime loans aren’t the only — or even the worst — problem.

Alt-A loans, or liar’s loans, that required no income or employment verification, reach their peak default year in 2009. And Alt-A loans comprise a $1-trillion market, compared to the $885-billion total for subprime loans, according to Inside Mortgage Finance.

The Alt-A loans are already in trouble, with Bloomberg data showing 16 percent of loans made since January 2006 some 60 days late. RealtyTrac is forecasting further defaults in the next few years.

Most people don’t understand that the Alt-A market is larger than the subprime market, and don’t realize how much of the mortgage mess still remains, said Dimitri Papadimitriou, president of the Levy Economics Institute of Bard College in New York. “A lot of people really have no idea of the size of this,” he said. “If you want to paint a depressing picture, it’s quite possible.”

In the meantime, payment option adjustable-rate mortgages, that allow borrowers to choose the amount of their monthly payments, begin their three- and five-year resets in 2009, and continue for the next three years — or for the duration of new president’s entire first term.

These loans allow borrowers to pay only the interest on their loans for the first few years. But then their payments jump dramatically, and some borrowers may be facing increases as high as 63 percent, Fitch Ratings concluded recently. That kind of hike could add an extra $1,053 per month to a borrower’s payment.

“The POARMS are definitely the next disaster waiting to happen,” said Kathleen Keest, senior policy counsel at the Center for Responsible Lending.

It’s not likely that borrowers will sell or refinance their way out of any of this, given that the steep decline in home prices is only likely to continue. Nearly 1 in 6 homeowners now owe more on their mortgages than their homes are worth, according to Moody’s Economy.com.

“With more people upside down, if you lose your job, or someone gets sick or hurt, it’s even easier to make the decision just to walk away,” said Lawrence White, an economics professor at New York University’s Stern School of Business.

Add to that the deteriorating economy, which is likely to ensnare more and more prime borrowers, who could lose their homes to foreclosures because of rising unemployment, corporate cutbacks and layoffs.

“You don’t have to overanalyze the situation,” noted Cecala, of Inside Mortgage Finance. “All these problems are just going to get worse.”

Given all this, the new president may not be able to wait until he takes office to take action, said Desmond Lachman, a financial markets expert with the American Enterprise Institute. The credit crisis is so severe that Obama should begin stepping in immediately, possibly by using his position as a senator to propose a stimulus package, Lachman said.

Martin Feldstein, a Harvard University economics professor and adviser to the campaign of GOP Sen. John McCain (Ariz.), first pushed that idea in a Washington Post op-ed last week. His point was that with both candidates also serving as senators, both had options to act early, if elected. From Feldstein:

Further legislation to deal with the economic crisis should not wait until the new president takes office. Fortunately, the president-elect will be a senator and can propose legislation without waiting to be sworn in as president. Immediately after Nov. 4, the winner could, and should, take the lead in the legislative process.

The problems with mortgages are just one piece of the bigger credit crisis, which has shown little sign of improvement despite the $700-billion government bailout, Lachman said. The auto industry is imploding, consumer confidence is at a record low, and home prices keep falling. Banks stubbornly refuse to lend. If the new president-elect waits until his term in office begins to start moving on the crisis, it could be too late, he said.

“The economy is literally falling off a cliff,” he said. “We’re just in this downward spiral. In my view, you can’t wait until March or something. There’s a lot riding on this.”

The new president will have to make decisions that may be bold, unorthodox and with unfortunate long-term consequences, Lachman said. But the dire economic situation will give him little choice.

And it’s not just the start of his term that will be consumed by the financial crisis, Lachman said. Obama may find his entire presidency defined by difficult economic times, just as Franklin Delano Roosevelt did, some 75 years earlier. Friday’s news conference on the economy – Obama’s first as president-elect — marks only the start of a long battle ahead.