Though news of increased defaults from the sub-prime market continues, a combination of rising incomes and higher equity values are shoring up consumer spending.
Reports of trouble in the sub-prime housing market have been trickling in since late last year, when two sub-prime lenders, Ownit Mortgage Solutions and Mortgage Lenders Network, filed for bankruptcy. The phenomenon has assumed more menacing overtones after New Century Financial, the second biggest mortgage lender in the United States recently admitted to difficulties in repurchasing old mortgages.
Trading in the New Century Financial shares has since been suspended and a bankruptcy filing by the company seems imminent. The fear of contagion, whereby the problems of the sub-prime mortgage market would spread to the housing sector as a whole and nip a feeble US economic recovery in the bud, has federal authorities scrambling to contain the problem.
Subsequent assurances by federal authorities, seeking to minimise the impact of the sub-prime crisis, are being increasingly perceived as attempts to allay domestic and international fears that the US economy is headed towards a housing-induced recession.
The growth in sub-prime lending reflects a natural evolution of credit markets that has resulted in more liberal lending patterns by lenders and financial institutions. Successive governments seeking to promote home ownership, especially among minorities and other groups traditionally marginalised by prime lenders, pushed legislation that provided a strong incentive for lenders to make loans to borrowers with poor credit histories.
The most important of these, the Depository Institutions Deregulatory and Monetary Control Act (1980) permitted lenders to charge higher interest rates to borrowers who posed elevated credit risk, rather than deny credit altogether.
The growth in sub-prime lending has continued unabated since the early 1990s. The number of sub-prime organisations grew tenfold between 1994 and 2003. Prime mortgage lending also increased at an annual rate of 17 per cent during this period, reflecting many of the same trends. Between 2000 and 2005, the quantum of sub-prime loans increased fourfold from $150 billion to $650 billion.
The high risk of default on repayment due to the weak financials of sub-prime borrowers makes sub-prime lending an inherently high-risk activity. Historically, the proportion of sub-prime loans that have resulted in foreclosure has been approximately 7 per cent, against 1 per cent for prime loans.
It is the near doubling of this proportion to about 13 per cent in late 2006 that has set alarm bells ringing. Expectedly, interest rates on sub-prime loans are higher than on prime loans, typically by three to four percentage points (10 -12 per cent, as opposed to 6-8 per cent on prime loans).
The jury is still out on the depth of the current crisis in the sub-prime market and its impact on the housing sector as a whole. Richard Berner of Morgan Stanley feels that fears of contagion in the housing market as a result of troubles in the sub-prime market are exaggerated: while many firms specialising in sub-prime loans will go under, the robust health of prime lenders would ensure that the housing sector as a whole stays afloat.
Not everybody is as sanguine about potential impacts of the crisis as Berner.
Susan Wachter, Professor of Real Estate Economics at the Wharton School, estimates that nearly two thirds of all loans issued since 2003 are "aggressive" in nature. Wachter's calculations, if true, would suggest that the problem is more deep-rooted than earlier believed. Topping the list of concerns is a credit crunch, whereby lenders would err on the side of caution and deny loans to borrowers with credentials otherwise deemed acceptable, thereby further dampening housing sector recovery.
An increase in interest rates would also extend the woes of an already beleaguered housing industry. Short-term interest rates have increased from 1 per cent during the summer of 2005 to 5.25 per cent today, resulting in a 30 to 50 per cent increase in mortgage payments for homeowners who obtained sub-prime loans around 2003. The delinquencies seen so far are only the tip if the iceberg, feels Wachter.
Mortgage payments of several borrowers who opted for floating rate loans during this period are yet to be impacted by the recent increases in interest rates. More delinquencies and foreclosures are sure to follow. The glut of homes arising from increased foreclosures would depress home prices on the prime market as well. The unfolding of this scenario has potentially severe implications for the US economy.
There is little doubt that US economic recovery will be significantly impacted by the performance of the housing sector in the days to follow. The downward revision of 2006 Q4 US economic growth from 3.5 per cent to 2.2 per cent was largely because optimism about the 'recovery' of the US housing sector was premature. Wachter estimates that the economy "has already lost about one percentage point of economic growth due to the pullback in the housing market".
David Wyss, Chief Economist at Standard & Poor's, broadly concurs with this estimate. However Wyss, like Morgan Stanley's Berner, is more confident that the sub-prime mortgage crisis can be contained.
Reports by the US Department of Housing and Urban Development, that privately-owned housing starts of 1.53 million during February 2007 were 9 per cent above the revised January 2007 estimates of 1.4 million, provide some evidence that the housing sector is on the mend.
However, its robustness will be seriously tested in the coming months. Wyss's worse case scenarios, based on a combination of sharp interest rate hikes and declining home sales and prices result in a 10 per cent chance of a housing-induced recession during 2007.
The International Monetary Fund, in its recent update on the economic outlook for 2007, also doesn't see much impact of the sub-prime phenomenon on US growth, which it believes will be 2.2 per cent this year. But, it expresses concern about the build-up of unsold housing stocks, which are now at a 15-year high.
Anaemic housing sector growth over the last year has predominantly affected industries linked to construction, such as building material manufacturers, furniture makers and appliance manufacturers.
Consumer spending, which was a significant driver of US economic growth during 2006, has not yet been significantly impacted by stagnation in home prices, largely because a combination of rising incomes and a 'wealth effect' due to the stock price increases, provided consumers with additional spending leeway.
However, a decline in stock prices, coupled with a general economic downturn, could lead consumers to exercise more caution in their spending habits.
The emergence of sub-prime market credit over the past two decades has definitely increased credit opportunities and home ownership, especially for low-income households and minorities, who have traditionally been denied prime loans. Home ownership, the cornerstone of the 'Great American Dream' touched 70 per cent in 2004.
The most conspicuous feature of this increased home ownership has been the distributional aspect. Proportionately, many more minorities and low-income individuals have been able to realise their dream of owning a home, largely due to access to sub-prime loans.
However, this greater inclusion has come at a price. Indiscriminate lending to borrowers lacking the wherewithal to meet their financial obligations threatens to wipe out hard-earned gains. The challenge to public policy is to combine regulatory oversight to protect naïve borrowers from predatory lenders with the laudable social objective of more inclusive access to finance, whether for home ownership or anything else.
The writer is a senior economist at CRISIL
