|
You no doubt have had at least a few moments of doubt and concern at the recent stock market volatility. The bad news is that stock markets are ultra–sensitive to bad news, such as the recent turmoil in the subprime mortgage market. The good news is that the kind of volatility we’ve seen over the past few months is probably not a sign of economic apocalypse.
Anyone with a mortgage, credit card, or new car is well aware that credit conditions have been fairly easy for the past five or six years. As recently as a few months ago, the world was still awash in liquidity. Then came the “subprime meltdown.” The time line went something like this: In response to recessionary conditions in 2001, aggravated by the events of September 11 and the bear market, the Federal Reserve began injecting liquidity into the economy. It did this by buying bonds from banks with money that it prints for just this purpose. This act of monetary policy is commonly referred to as cutting interest rates, but the Fed doesn’t actually control interest rates. It alters the money supply so that it outstrips demand, thus causing interest rates — the price of money — to fall in the marketplace. The banks took this surfeit of cash and began making loans, many to homeowners and home buyers. When the good credit risks had their fill of low–cost loans and cash–out refinancing, the banks began to target riskier or “subprime” borrowers. At the height of the credit boom in 2004, the share of subprime loans went from 4% of total lending to a whopping 10% of total lending. (1) This spike in subprime loans, since dubbed a bubble by some commentators, helped stimulate demand for real estate by increasing the pool of eligible buyers, which in turn helped drive up home prices. Adjustable Woes Many subprime loans were made with adjustable rates that offered appealing introductory rates but would later adjust upward, perhaps more significantly than many buyers anticipated. Many loans were also given to buyers who were not required to fully document their incomes (45% of subprime loans went to such buyers in 2006), allowing some to borrow more money than their creditworthiness might have allowed in less heady times. (2) During this time, home prices were rising so rapidly that borrowers who were having trouble making payments could simply refinance, keeping defaults artificially low. This may have masked the true risk of loaning money into the subprime market, causing the major credit–rating firms to possible overrate the credit quality of some subprime mortgage debt. (3) Wall Street and Main Street Banks This crisis might have garnered less attention on Wall Street were it not for a recent sea change in the way the mortgage market is organized. In the past, banks were the most common originators of mortgages, and federal deposit insurance encourages depositors not to make a run on their banks when they get in trouble. But after the savings and loan crisis in the late 1980s and early 90s, banks were required to keep more capital in reserve against subprime loans. This shift in the regulatory landscape helped foster an environment in which non–bank mortgage lenders flourished. Unlike banks, which lend depositor capital, these newer lenders relied on credit from Wall Street and the “securitization” of their loans. Wall Street was so eager to buy mortgage loans from banks to sell to bond investors that even the demand for subprime mortgages spiked. Then, when adjustable rates adjusted upward, some subprime borrowers could no longer make their mortgage payments. As a result, subprime defaults have fallen less on banks than on bond investors who may not have understood the true risks of investing in subprime mortgages. When one of the nation’s largest subprime lenders was forced into bankruptcy in early 2007, leaving its shareholders to help absorb the loss, it created uncertainty about the future of the subprime business and, by extension, the global availability of credit. (4) Fear and Loaning The current fallout in the financial markets is less about what has happened so far than about the fear that subprime situation might be a sign of more defaults to come. This fear has caused a reluctance among investors who buy loans. Lenders need to sell their loans in order to raise funds to keep lending. Investors began refusing to buy mortgage–backed securities that were once thought to have unquestionable worth, opting instead to lock up their cash in safer short–term Treasury debt. (5) This caused a dearth of credit–market liquidity, notably in the commercial–paper market, which is a source of short–term funds for a broad range of companies. These companies rely on such short–term funds to finance operations, and a shortage could slow economic growth, the fear of which is responsible for some of the stock market volatility we have been seeing. Fed to the Rescue These developments led the Fed to decide it needed to step in to help restore confidence. The Fed’s early response was to cut the interest rates on the discount window, which is traditionally considered a last resort for banks needing to borrow money. Banks normally don’t like to borrow from the Fed because it can be expensive and casts doubts over a bank’s solvency. By assuring banks that they could continue to borrow against their outstanding mortgages without impugning their reputations, the Fed was able to help restore some confidence, at least in the short term, in the credit markets, and thus the rest of the financial world. (6) In addition, other central banks around the world, notably the European Central Bank, began pumping cash into the financial markets through inexpensive loans to commercial banks. (7) Federal Reserve officials have stated publicly that the subprime problems should remain contained and there is no evidence that they will spill into the prime mortgage market or the broader economy. (8) So far, the evidence bears this out: The actual number of subprime loans in default is but a fleck in the sea of mortgages. Of the 44 million outstanding U.S. mortgages, less than 14% are subprime and about 13% of these are late on payments. In all, about 0.06% of total U.S. mortgages are in default, up slightly from the 0.05% rate in 2006. (9) Red October However, an unusually high number of variable–rate mortgages were scheduled to reset in October 2007, when an estimated $50 billion in mortgages will adjust upward from their introductory rates. Thereafter, an estimated $30 billion worth of adjustable mortgages will adjust each month until September 2008. One analysis has predicted about 1.7 million households could lose their homes. (10) A flood of foreclosures and fire sales could further depress housing prices. Still, many market observers seem fairly confident that the housing market is unlikely to cause a bear market or a recession because the rest of the economy remains strong. (11) Nonetheless, we can probably expect the stock and bond markets to take some more time to become comfortable with shifting credit conditions. 1) NRO Financial, August 14, 2007
Understanding the Credit Crunch
|
