Nitwit lenders put the economy at risk -- again

By Scott Burns

Last time I dared look, the financial sector of our economy accounted for about 20% of all market value. At the end of June, for instance, financial services accounted for that much of both the S&P 500 Index ($INX) and the broader Russell 3000 Index.

Either way, financial services are a hefty chunk of the market pie.

It's a bit reminiscent of technology in 1999 -- except the price-earnings ratios are lower and no one expects Bank of America (BAC, news, msgs) or Citigroup (C, news, msgs) to triple in the next month.

Otherwise, what we see all around us is a great symphony of financial-sector excess. We could talk about hedge funds, private-equity funds, derivatives or even the ridiculous growth of exchange-traded funds. But let's not be so esoteric. Let's stay closer to home. Let's talk about mortgage lenders and the residential-real-estate market.

That's where most Americans, if they have any net worth at all, have their biggest bet. Until you're in the top 10% of all households, home equity is what it's all about.

Yet our friends in the lending business have, once again, lent us into a period of misery that may last longer than we want to contemplate.

Once again?

Yes, once again.

The sordid record

Remember the real-estate-investment-trust bust of the late 1970s? It was driven by carelessly generous lending. The big commercial banks fell over each other making big loans to real-estate developers. The developers built whatever they wanted to build. Each assumed that his project would be successful even when it was clear that many projects would not be occupied for years. Competitive sheep bankers lent the money.

When that bust ended, commercial-realty brokers were joking that you could have your name on a building if you'd promise to open a shoeshine stand in the lobby. Chase Manhattan Bank nearly became a casualty, given the excesses of its REIT. In Boston, I remember attending the shareholders meeting at the Ritz Carlton where the esteemed Cabot, Cabot and Forbes Land Trust declared that it was no longer capable of paying its dividend.

Too much got built, too fast.

Or how about the savings-and-loan bust of the 1980s? That bit of excess wiped out the entire S&L industry and sent a megabillion-dollar bill to Congress -- which you and I collectively paid. Though the epicenter of that bust originated in Texas with land flips, congressionally allowed funny-money accounting, buy-down mortgages and no-down-payment home sales, the same thing happened (albeit on a less Texan scale) in the rest of the country.

Clearing away the wreckage took us well into the 1990s.

Today, yet another wave of nitwit lending has put the entire financial system at risk, and the subprime mortgage mess is only part of the problem. The rising wave of adjustable mortgage rate resets is a larger problem.

A moment of truth

As John Mauldin points out in a recent newsletter, resets scheduled for next February and March alone will be more than all the resets in the first six months of this year, $197 billion. Resets in the first six months of next year, $521 billion, will be greater than all of 2007.

Talk about moments of truth. That's when many owners will become renters and many lenders will become harried owner/sellers. Then, not now, is when the housing market should start to bottom. It's also when consumers will be tightest with their spending, so we're likely to see a weaker economy than we see today.

It would be easy to "Armageddonize" this -- and you can read plenty of blogs doing just that -- but it's really just an unnecessary replay of earlier surges of nitwit lending. We're going to have to tough it out. And we will.

Be smart and change your behavior

What's the lesson here?

Easy. Lenders have proved themselves to be unrelentingly dull-witted altogether too often. If they aren't smart enough to change their behavior, we have to change ours.

First, don't borrow money just because a lender makes it available.

Second, ask yourself whether you'll be able to pay it back. Your lender is clueless, so it's up to you to know.

Third, don't plan on being able to sell anything quickly or easily because these jokers can't be relied on to provide a steady and reasonable flow of financing. When their own foolishness comes back to bite them, they invariably make things worse by reducing lending, making a bad situation worse.

Watch them do it now. They will call it "prudence."

Questions about personal finance and investments may be e-mailed to scott@scottburns.com. Questions of general interest may be answered in future columns. More columns by Scott Burns can be found here.