May 14, 2007
Left Out In The Cold: The Impact From The Sub-Prime Mortgage Collapse
by Beth Ann Bovino
The house party has started to wind down. The result of these excesses has finally started to appear. Big sub-prime mortgage lender New Century Financial has filed for bankruptcy, while tens of thousands of sub-prime borrowers are unable to make their payments. Defaults on these mortgages, which are granted to homebuyers with low credit scores, and who have bought their houses with little or no money down, have increased sharply with little signs of slowing down.
While it is obvious that homeowner defaults hurt mortgage-lenders and homeowners, these defaults must be put in a broader economic context. Questions include: How will they affect the broader housing markets? Will it spread into the larger economy? Who will be hurt and how? What will the impact of sub-prime problems damage credit availability? How can it be solved, and will the solution will be worse.
The turmoil in sub-prime lending is significant. David Wyss the Chief Economist and my boss at Standard and Poor’s expects the weakness to last at least through the end of 2007 (see “We Call It Sub-prime for a Reason”). He said that “today’s losses have been propelled by a confluence of two factors—rising interest rates that have made mortgages more expensive since late 2005 and stagnating home prices, as opposed to the surging gains prior to 2006. Low interest rates or double-digit gains in home prices aren’t likely to return in the near-term”. Thus, conditions in the sub-prime market will probably get worse before they get better, with foreclosures likely near 12% by 2008.
The current problem is largely confined to the sub-prime adjustable-rate mortgage (ARM) mortgage market. In contrast, the fixed-rate market is showing no sign of strain. However, homeowners with adjustable-rate mortgages are coming under financial pressure. Although the economy remains generally strong and unemployment low, higher interest rates are squeezing mortgages that stretched too much to buy their homes. Foreclosure rates are rising, although they still remain moderate by historical standards and are far below their recent peaks in 2001 and 2002, during a recession. The impact from losses will be felt through the economy, though the extent of the damage is still unknown.
In Mortgage Holders
The recent drop in interest rates to historic lows generated enormous demand for housing. The housing boom led to record levels of home ownership, but it also led to record home prices as many Americans bought bigger homes than they could comfortably afford. It was affordable at a 5% mortgage interest rate, but hurts at the current 6.2%. Lenders also dramatically increased their number of mortgage products in order to reach more homebuyers, including those who they might otherwise have excluded. Most home mortgages are still high quality and unlikely candidates for default. But sub-prime loans and new forms of financing increased the overall risk.
Households, on average seem to be in good shape. Although household wealth remains well below its 1999 record ratio of 615% of after-tax income, at 575% it is still well above its historic average. Debt service payments are at a near-record 14.5% of household income, but seem manageable. But some households are likely to be in trouble. The 2004 Survey of Consumer Finances showed that 12.2% of U.S. households (up from 11.8% in 2001) have debt-service burdens that exceed 40% of their income (see CreditWeek, April 13, 2007 and April 25, 2007). It is likely that this category may also have a higher share of adjustable-rate mortgages.
As rates adjust upward more holders of adjustable rate sub-prime loans will likely be unable to pay their monthly bills. Adjustable rate mortgages are about one-fifth of new mortgages according to the Mortgage Bankers’ Association, but are a much higher share of sub-prime mortgages. In the past two years the sub-prime market accounts accounted for about 20% of all mortgages, and 40% of all adjustable-rate and interest-only home loans in 2006. The higher monthly payments are probably a factor in the rise in delinquency rates, which up sharply from last year. They are still well below their historical averages, much less their recession peaks. However, the 4.25 percentage point rise in short-term interest rates that began in mid-2004 has still not been completely passed through to mortgage holders, and more rough waters are likely ahead.
Impact on the Economy
The difficulties of sub-prime lenders will likely affect the economy because there will be more foreclosed houses on the market, on top of the unsold homes held by individuals, new home construction should drop even more. During the second half of 2006, declines in residential construction activity cut GDP growth by a full percentage point. Double-digit declines in residential construction will continue through most of 2007, depressing GDP. It will also exacerbate the loss of income in the construction industry.
So far the indirect impact of housing on the economy has been small. Consumers have not quit spending. Despite record consecutive months with the personal saving rate remaining below zero (-0.8% in March), Americans haven’t lost their appetite to accumulate more debt. However, the higher interest rates, more so than slower home appreciation, will probably cause the consumer to cut down on borrowing, and thus eventually spending. The strong stock market has offset the lower increase in housing wealth. However, this could be at risk if stock prices fall.
Whether the higher cost of borrowing and slower rise in the value of home equity will slow borrowing remains another big concern. Americans have been using their homes as ATM machines, through home equity loans and cash-out refinancings. The average American borrowed 3.5% of his income last year. Low interest rates made these loans cheap, especially since they were usually tax-deductible. With a slower housing market and higher interest rates, this will almost certainly slow. According to Freddie Mac, the amount consumers borrow against their homes to finance other activities could drop 20% and another 30% over the next two years. More homeowners will be faced with the choice of borrowing from other sources or not borrowing at all. While those with strong credit may be able to borrow from other sources, many sub-prime borrowers could find those alternatives closed to them.
Those outside the mainstream credit system, with no credit history, fall into the sub-prime group by default. They will likely face greater barriors to entry, simply because lenders currently lack the right tools to adequately assess the credit risk. The Brookings Institution and Political and Economic Research Council reported that new studies have developed ways to increase access to affordable credit by using alternative data in consumer credit reports. This could help reduce some of the roadblocks for this group in the future, but not in the near-term.
The Federal Reserve may begin cutting rates later in the year as markets expect. However, there has been little impact on long-term bond yields, and thus fixed-rate mortgages, since mid 2004, when the Fed began to tighten, so Fed cuts will also likely have little impact. Adjustable-rate mortgages will become cheaper, however, which will begin to help sales, and should moderate the impact on adjustable-rate borrowers.
Risks To The Recovery
Overall, lenders were way too enthusiastic in lending money to people who couldn’t really afford the payments. When investors have been too complacent about risk, and get stung, they often overreact and become too cautious. This impact could be compounded by legislative actions that would punish the lender for making bad loans. The lack of availability of mortgages could make a recovery in the housing market very difficult.
The biggest worry isn’t the sub-prime market itself, but the possibility that the housing market’s problems could be aggravated by a general recession, say, if oil prices surge. Increased legislation created to help homeowners, may also restrict the ability of lenders to write mortgages or impair the value of the collateral by restricting foreclosures. The market would likely react by making mortgages more expensive and harder to get.
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