The subprime mortgage market has caused a convulsion on Wall Street with several analysts insisting it foreshadows a deep recession. There is little question that a sharp increase in delinquent mortgage payments has been due to loans made to borrowers with weak credit.
The combination of an accommodative Federal Reserve, political pressure to assist poor home owners and a belief that property appreciation would offset debt resulted in a perfect market storm.
The subprime market caters to borrowers with impaired credit histories. Of the $7.8 trillion in residential mortgage debt outstanding in the United States, subprime debt accounts for $824 billion, or about 10 percent of the total. Although subprime represents only a small proportion of the debt, a rapid rise in early payment defaults has strained lenders and caused heightened concern over the quality of loan originations.
Further problems could occur as adjustable rate mortgages are reset at much higher interest rates resulting in payment spikes. Financially strapped borrowers are experiencing difficulty refinancing or selling properties while lenders, sensitive to roiling property markets, are tightening their underwriting standards and reducing the availability of credit.
As is often the case when a benign economic environment turns volatile, the magnitude of risk taking is coming into focus. The environment of abundant liquidity may have had its roots in an extended period of easy monetary policy, but the driving influence in the past few years has been rampant credit expansion in the financial sector.
While the working class homeowner may face foreclosure – a matter that goes right to the heart of American culture (cite “It’s A Wonderful life”) – the odds of a systematic financial crisis, notwithstanding “the sky is falling” economists, are slim. Credit problems are likely to spread across a number of investors and lenders rather than be concentrated in banks, as often occurred in previous credit stress.
Recognizing the impending crisis, the Fed largely uninterested in bailing out investors from bad decisions and having taken the view investors have been far too aggressive in pricing risk, will nonetheless move to deal with the threat to the intermediation of credit. My guess is the Fed will ease rates and the Congress, bent out of shape by the political fallout of foreclosures, will call for measures that distinguish between sound and loose credit features.
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