Subprime Mortgage Debacle: What is the Impact?

Last year, the market overcame a wrenching period of soul-searching in May and June (2006). Back then, the Federal Reserve was at the end of a two-year campaign to raise interest rates, and the housing boom had started to fade. The concerns that dominated the minds of investors, however, did not linger, and the market had a solid second half.

Many market specialists assert that the current concerns will play out similarly. Weaknesses like those in the market for subprime mortgages issued to borrowers with weak credit will not threaten the broader financial markets, these experts say, because the world economy is growing, corporate profits are rising, and consumers with good credit are not defaulting at high rates.

Most of us (especially those living in areas with very high housing costs) are aware that lenders have pushed the envelope in recent years and granted loans to enable people to buy homes they would otherwise be unable to afford. In so doing, many of these buyers have stretched themselves financially and have little margin for error. Low starter rates and temporary interest-only terms are winding down or expiring. The rates on these loans are resetting at a much higher level because interest rates are rising. As a result, defaults among subprime mortgages have climbed sharply. How widespread is the problem? Well loans in this segment ac-counted for 24% of loan originations in 2006, and late payments in Alternative-A mortgages are esca-lating (the default rate in this sector is in the 13% to 14% range). The result: people are losing their homes and some subprime lenders have either experienced big financial losses or gone out of business.

Research analysts at PIMCO have suggested that this is a meaningful source of risk to the housing market, since these defaulting buyers have starter homes (less expensive homes) which are the first rung on the housing-market food chain. So on its face, rising delinquencies in a high-growth part of the market could be a serious concern.

Defaults and tighter lending standards will mean that growth in the subprime arena will stall, causing demand to sag even further in the housing market. PIMCO’s analysts believe that we’re in the middle of the housing downturn, and that this will ultimately cut roughly another 1% from GDP growth over the next few quarters (and that there is at least some risk that it could be worse). Clearly that’s not good, but it is also not as bad an outcome as many others seem to expect given the extensive media play that this problem has received.

The reason the spill over effects on the economy and corporate earnings aren’t more severe becomes clear when you break the U.S. consumer into quintiles. The bottom 20 percent of U.S. consumers generate only 8 percent of consumer spending. These are the very consumers that are caught in the sub-prime lending squeeze and could lose their homes. Conversely, the top 10% represents about 40% of consumer spending and these consumers are unaffected. The subprime debacle will effect will cause dislocations in the housing market but won’t deliver a crippling blow to the economy. It is just another road hazard that the economy and financial markets will need to navigate around.