Perfect storm of debt rattles Wall Street

Hedge funds are collapsing and banks fear plunging profits, but low-income Americans will be the real victims. James Doran reports from New York.
A rare tornado wreaked havoc in New York last week, sparking chaos across the city. But, as commuters picked through broken tree limbs and flattened cars, a whirlwind of another kind tore along Wall Street.

What started as a squall at the grubby end of the mortgage market has become a perfect storm of debt. Wall Street's giant investment banks are being sucked into a crippling credit crunch. The Securities and Exchange Commission is even rumoured to be examining the major banks to determine their vulnerability to the defaults. Two hedge funds run by bank Bear Stearns have been made bankrupt and a third frozen. The company has now hired law firm Davis Polk & Wardell to conduct an inquiry into the collapses.

Less than an hour after the bankruptcy filing, Warren Spector, the bank's co-president and supposedly one of Wall Street's best debt and mortgage market men, was summoned to the office of James Cayne, his chief executive. Cayne said he should take responsibility for the bank's failure to protect itself. The share price was down 27 per cent and Standard & Poor's, the credit rating agency, had raised a red flag over the bank, shifting its outlook from 'stable' to 'negative'. Someone had to take the fall.

Spector had been considered the most likely to succeed his chief; now he was the first high-profile casualty. As he now watches from his home on Martha's Vineyard, more twisters are touching down on Wall Street, sending investors and bankers running for cover.

Bear Stearns was not the only bank with huge amounts of mortgage business. Lehman Brothers did the largest amount on Wall Street, analysts say, but it seems to have avoided Bear Stearns' troubles thus far.

Goldman Sachs, the most profitable investment bank on the Street, revealed that two of its hedge funds were experiencing difficulties. Then BNP Paribas, the French banking group, admitted similar related woes at three of its hedge funds.

But, big as the problems facing Goldman, Bear Stearns and BNP seem, these are isolated showers compared with the storm brewing. There are few buyers for even the least risky of bonds, while those labelled junk will not be touched with a barge pole. Similarly sentiment is gripping the equities markets, with shares plunging each time more bad mortgage news emerges.

The European Central Bank, the US Federal Reserve and the Bank of Japan were all forced to inject cash into the financial system because there was too little liquidity - meaning very low levels of trading - and banks are not generating revenue so profits are set to dive.

Indeed, many analysts believe that Wall Street profits for the second half of the year will be 30 per cent lower, the greatest drop in years. This would be difficult to weather without passing on the pain to bankers tightening their belts for an expected round of job cuts.

But the banks and the bankers will survive. The real victims are ordinary Americans, for whom buying a house and all the prosperity and security that comes with it is now just out of reach. The sub-prime market was not designed to saddle the unsuspecting borrower with usurious terms for life. In fact, there were some very useful mortgage products that gave many Americans a leg-up on to the housing ladder .

Now, with the banks in panic mode, the American Dream will be banished for many until Wall Street wakes up from its credit-crunch nightmare.

'I am fighting. I don't want to lose my home'

Paulina Matherin has dreamed of owning her own home in the United States ever since she was a teenager in St Lucia. But her hopes have turned to dust as she and her brother John have fallen victim to the US housing crash and face losing their home.

Unlike many others, Paulina and John resisted taking on too much debt at a time when interest rates were low but still found themselves unable to afford repayments when the cost of borrowing rose.

The Matherins were stalked by predatory lenders who persuaded them to remortgage their house before using their credentials to obtain hundreds of thousands of dollars in their name. And theirs is not isolated case. Lax lending rules have allowed American homeowners to amass billions of dollars of mortgage debt they have no means of repaying. They have also left the door open for countless fraudsters who have exploited their clients' desperation to obtain the loan funds.

'The man we dealt with is wanted for defrauding more than 200 other people in New York alone,' says Paulina.

Paulina, who is 58 and practises alternative medicine from her house in Brooklyn, New York, saved for 15 years to afford the modest $169,000 (about £83,000) mortgage she needed to buy her first home in 1996. 'I have lived in the US for 24 years and I never thought it would come to this,' she says, 'I am fighting this all the way. I don't want to lose my home.'

Her story charts the rise and fall of the US housing market and shows how unscrupulous banks and brokers have ensnared vulnerable clients in a cycle of debt and default.

Paulina's first mortgage was taken out with a small sub-prime lender called Apple Credit. As she had a poor credit history, she needed her son to co-sign her loan and Apple sold her a loan with high fees.

But, like many other small sub-prime lenders whose collapse has contributed to the current credit crunch affecting banks as far apart as France, Germany and Hong Kong, Apple Credit didn't last long and soon went bust itself.

'They were involved in some kind of fraud and closed down,' Paulina says. 'I kept sending my payments through Western Union, but nobody told me that before they went bust Apple Credit had sold my mortgage to the Bank of New York.' She continued to send her payments to Apple Credit and the Bank of New York received nothing. After six months, the bank initiated automatic foreclosure proceedings.

However, as soon as her house was listed as ready for foreclosure, Paulina was inundated with offers of new loans from local brokers eager to capitalise on the housing boom in 2004.

'A company called Lost and Found promised to get my house off the foreclosure list, pay my mortgage for a year, restore my credit and sort everything out,' says Paulina. Instead, it is alleged, brokers dealing with her case applied for loans worth hundreds of thousands of dollars in her name. Her house was back on the foreclosure list.

Although Paulina's case might seem unusual, the increase in recent years of fraudulent mortgage schemes and loan defaults are both key factors in the current global credit crunch.

'While the lending guidelines were loose and house prices were rising the increase in the number of frauds was crazy,' says David Tankin, Paulina's lawyer who specialises in helping homeowners prevent foreclosure. 'The fraud problem has reached such epic proportions that it is hitting ordinary middle class people and not just the sub-prime end of the market.'

Scott and Latosha Bickel live near Paulina in Brooklyn. The couple are both teachers and own their own home. They spent the summer trying to buy a holiday home but almost lost all their savings when their mortgage company went bust on the day their purchase was due to complete. Their lender was American Home Mortgage, which reportedly lends only to borrowers with employment and income history.

The Bickels were lucky enough to find another lender but Paulina - and millions like her - could still lose everything.

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