Fallout From the Mortgage Fiasco

Mark Zandi is chief economist and co-founder of Moody's Economy.com. His book, Financial Shock: A 360-Degree Look at the Subprime Mortgage Implosion and How to Avoid the Next Financial Crisis, was published in August by FT Press.

Is the crisis over? Or nearly so?

We have another year to go until we hit rock bottom. House prices will be back to levels consistent with incomes and rents, banks will have figured out how much capital they need and will be on the way to raising it, and unemployment will have peaked. From peak to trough, home prices will be down 25% nationwide -- we have another 10% drop to go, back to where they were in late 2003. Unemployment will peak at 6.5% in the summer of 2009 from a low of 4.4% in early '07. And the total losses on mortgage-backed instruments originated through 2007 will mount to about $1 trillion, out of a $27-trillion credit market. We haven't seen anything like that since the Great Depression.

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And the lessons learned?

As investors and savers, we've had significant tail winds in the form of falling interest rates and rising asset values. Those tail winds are gone. The pressure is going to be greater to be fiscally disciplined -- as households, and collectively, through our government. If we're going to be prepared for the future, we're going to have to save more, and that's not just a hollow slogan.

Where do you see the next crisis forming?

The arithmetic of our fiscal situation is very daunting. Some people think we can get away without raising taxes or cutting spending, that we can live with large deficits. But as our deficits rise -- and they will because aging baby-boomers will require more medical care and Social Security -- the Treasury will have to issue more bonds. Global investors will want a higher interest rate to take on that increasing mountain of debt. So at the end of the day, we'll have to do both.

How can we avoid financial bubbles and the panics that ensue?

We have to learn that when prices for some asset are rising quickly, it's not a signal to invest more aggressively -- it's a signal to invest less because you're becoming less diversified as the price of that asset rises. When housing values are rising really fast, that's not a time to buy that second home; that's when you trade down if you're an empty-nester.