Dissecting the subprime mortgage crisis

By Lisa Von Ahn

NEW YORK (Reuters) - Even as the economy continues to reel from the subprime mortgage meltdown, at least one expert believes the worst is over.

Mark Zandi, chief economist of Moody's Economy.com and author of the upcoming book "Financial Shock," says he is optimistic now that U.S. policymakers have gotten involved.

"I think it took a while for them to recognize the severity of the financial turmoil, and then it took them some time to figure out how to respond," he told Reuters. "Now I think they're on high alert and working very hard to try to stem the crisis.

"If history is any guide, once policymakers are engaged, that's the beginning of the end of crises."

"Financial Shock" (FT Press, $24.99), which is set to be published on Monday, explains why savvy professionals ended up loaning money to people who clearly couldn't afford to keep up their payments -- and why this wreaked havoc on the economy.

Zandi describes the financial chaos as an outgrowth of once-promising trends.

After the tech-stock bust of 2000 and the September 11, 2001, attacks, housing seemed like a logical place for U.S. consumers to put their money. And global investors, who had plenty of cash because of easy credit and a rising U.S. trade deficit, found bonds backed by pools of mortgages and other debt were an appealing alternative to U.S. Treasury bonds.

But the securities became increasingly complex and difficult to assess, home builders kept building even as the housing boom ran out of steam, and desperate lenders tried to keep the process going by expanding their pool of borrowers by offering "creative" financing. Regulators did little.

Zandi also touches on the role of credit rating agencies like Moody's, which have been blamed for making "exotic" mortgage securities seem safer than they were, but he refrains from discussing the subject in depth to avoid the appearance of a conflict of interest.

"The essential final ingredient was hubris: a belief that the ordinary rules of economics and finance no longer applied," he writes. "Everyone involved -- home buyers, mortgage lenders, builders, regulators, ratings agencies, investment bankers, central bankers -- believed they had a better formula, a more accurate model, or would just be luckier than their predecessors."

But instead, credit -- "the mother's milk of a well-functioning economy" -- dried up, Zandi wrote. As unemployment rose, consumers reined in spending and businesses curbed hiring even further so that "the self-reinforcing negative cycle that characterizes recession was now in full swing."

He offers various suggestions for reforming the financial system, starting with a mortgage write-down plan. The one included in the housing rescue bill signed by President Bush on Wednesday is a step in the right direction, he said, but he expects another plan next year, after a new president is elected.

Zandi said he was also encouraged by the Federal Reserve's new rules for mortgage brokers, another priority he had listed in his book.

Other measures that he recommends include expanding data collection, implementing a federal foreclosure process, educating high-school students about personal finance, increasing transparency and streamlining regulation.

But Zandi also holds the individual accountable. "We must each prepare for the next financial crisis by carefully considering the position of our own balance sheets," he writes. "We will have to save more and be more careful of how we invest.

"Instead of piling into the next new thing, we should be diversifying away from whatever is appreciating quickly."

(Editing by Brian Moss)