It's been a while since I did a 'Bubbles' Greenspan diary (see some samples at the end of the diary). In the past year, the bubble more or less stopped growing, and we were in that "twilight zone" moment where it's too late to prevent the crash, but it hasn't actually happened (or, in the cartoons, the moment when the coyote is already over the cliff, but has not yet realised that there is ground under his feet anymore, and hasn't started dropping down). As the slow motion meltdown of the subprime mortgage industry continues apace now, we are clearly entering a new phase, where the consequences of the recklessness of the past few years are becoming increasingly visible and dire.

And people on the markets are beginning to say a bit louder what some have been saying for years now, i.e. that a nasty bubble was created by Greenspan's Fed, that it has made a number of dangerous investments possible, and that these are beginning to look like what they really were, i.e. reckless bets on ever increasing asset prices.

Federal Reserve officials and most economists believe the problems in the subprime mortgage market will remain relatively contained, but there is compelling evidence that the failure of subprime loans may be the start of a painful unwinding of a housing bubble that was fueled by easy money and loose lending practices.

Whether measured in absolute terms or time-tested metrics such as price-to-income or price-to-rent ratios, the rise in U.S. home prices during the past six years is unprecedented. What's more, not only has mortgage debt doubled during this time, but loans have been offered on imprudent terms (for instance, a no down payment, no income verification loan to a borrower with a checkered credit history).

Of course, loose lending practises were themselves generated by easy money: as asset prices went up, they seemed to be one way bets, and downside protection was increasingly seen as a useless protection and an unnecessary cost. With cheap liquidity sloshing around, returns on safe investments also went down, thus forcing investors and banks to take increasingly risky positions to earn decent returns.

Far from being limited to the subprime market, the data show these risky loan features have become widespread. According to Credit Suisse, the number of no or low documentation loans -- so-called "liar loans" -- has increased to 49% last year from 18% of purchase loans in 2001, a nearly three-fold increase. The investment bank also found that borrowers put up less than a 5% down payment in 46% of all home purchases last year. Inside Mortgage Finance estimates that nontraditional mortgages -- mostly interest-only and pay-option ARMs that allow the borrower to defer paying back principal or even increase the loan balance each month -- which barely existed five years ago, grew to close to a third of all mortgages last year.

Foreclosure losses as a share of the economy will be small and most homeowners have a comfortable amount of equity in their homes. In fact, about one-third of homeowners have no mortgage and own their homes outright, but they are not the reason home prices have been driven to the stratosphere. Home prices -- like all prices -- are set at the margin.

It was the marginal buyer, particularly the subprime borrower and housing speculator, who drove prices higher. The easing of lending terms increased the demand for homes, and since the supply of homes is relatively fixed (or inelastic), this increase in demand quickly translated into higher prices. As the loose lending practices are inevitably reversed -- and there is a wide chasm between current lending practices and prudent lending terms -- fewer people will be able to afford to buy a house, which will reduce demand and push home prices lower.

It's not the size of foreclosure losses as a share of the economy that matters, it is the effect those losses have on the availability of credit. When banks (and investors in mortgage-backed securities) begin suffering losses, they inevitably pull back. This is why so many subprime companies have gone bankrupt virtually overnight; investors balked at buying subprime loans except at a steep discount, which produced immediate losses. In effect, their ability to profitably finance new loans was eliminated.

The whole market was one big pyramid scheme, with increasing leverage. With prices going up, banks were happy to lend to people with little money and no ability to pay back capital (counting on capital appreciation and a quick resale); the financial markets were happy to lend money to these lenders. The construction sector enjoyed a boom, the financial (and real estate) intermediaries made a lot of money, and consumers could use their money to buy more stuff in addition to buying houses. Asset price increases - which the process generated while it lasted - paid for it all.

Suddenly, higher repayment obligations (after the few easy early years) are kicking in, borrowers cannot pay - and cannot spend either, and their lenders are having trouble paying back their financiers. Prices are not going up anymore, and the whole cycle is no longer fed. Banks pull back finance, no new transactions happen, and the whole cycle collapses. Construction companies sit on unsold inventory; real estate agents see the number of transactions dry up; and the financial markets are left with huge assets of dubious value.

The twist is that nobody knows who actually holds these assets, as they have been sold, repackaged, re sold, transferred and spread around all over the financial universe. It will take a bit of time to unwind the whole thing. Early losses and difficulties will be kept silent and absorbed by institutions that have built up comfortable cushions in the boom years, but eventually some of it will come out - in probably unexpected places.

Which brings us back to our initial quote:

Asset bubbles are harmful for the same reason high inflation is: Both create misleading price signals that lead to a misallocation of economic resources and sow the seeds for an inevitable bust. The unwinding of today's housing bubble is not merely an academic question; it is likely to inflict real hardship on millions of Americans. To reduce the risk of a similar outcome in the future, it is important that policy makers, economists, and policy analysts properly diagnose the root causes of the current housing bust, not just its symptoms.

The root causes have been the combination of (i) a reckless administration spending like a drunken sailor (whether in the sinkhole of Iraq or in other corporate pork) and passing the cost on to future generation, (ii) an enabling policy by 'Bubbles' Greenspan's Fed, which unashamedly left the credit spigot open for a very long time (with ultra low 1% Fed rates) while saying nothing against the Bush deficits, (iii)complicit financial markets all too happy to gorge on the bonanza without any restriction, and (iv) clueless or complicit pundits cheering on the "economic miracle" and scolding those that did not participate (like Germany) for being stagnant and those that pointed at the bubble for being grumpy bores. Even the mild words of Jean-Claude Trichet, who recently restated the long standing policy of the European Central Bank (and before it, of the German Bundesbank) of worrying about broad money inflation and asset bubbles as well as about 'traditional' inflation, were mocked relentelssly in the financial press.

But, of course, assset inflation IS inflation, and the fact that it did not create consumer price inflation (because wages were kept down thanks to Chinese competition) did not mean it was not just as bad.

The unprecedented (and mostly artificial) 'prosperity' of the past few years has been captured exclusively by the very rich and their bankers. The task of the next few years will be to make sure that they also bear the brunt of the crash, and that they are kept away from the steering wheel for a long, long time. In a fair world, the poor and middle classes would not suffer any hardship, but we know that this will not be the case; the least we can do is to make sure that blame is properly apportioned and that the looting by the haves and the have mores is documented, publicised and seen for what it is so that at least it does not happen again. Because you can be sure that they will try again otherwise, over the dead body of the "lazy" middle classes.

Earlier Bubbles Greenspan diaries:
Greenspan's bubbles - more graphs
Greenspan's Bubbles: 'Too late to escape the consequences'
Debt to China - it's even worse than Krugman says
Bubbles Greenspan gets TWO blowjobs in the FT
Bernanke, inflation, China and the housing bubble
If Greenspan Was The Maestro, We're All Doomed by Drew J Jones
Bernanke faces tough year as he replaces 'Bubbles' Greenspan
That, which cannot go on forever, won't
WSJ on Bush economy: when in hole, stop digging