The Subprime Market Implosion and its Consequences

The subprime mortgage market has been dominating news lately with signs that rising defaults and delinquencies are wreaking havoc on the mortgage industry. Here are some of the headlines:

  • Accredited Home Lenders Holding Co. reported a $37.8 million loss for the 4th quarter — three times wider than analysts expected.
  • ResMae Mortgage Corp. became at least the 20th subprime lender to close or be sold when it filed for bankruptcy.
  • Freemont General Corp., a major lender to people with weak credit histories, announced that it has stopped providing “piggyback” mortgages.
  • HSBC added $1.76 billion to its bad-loan costs for 2006 to cover ailing mortgages.

At the start of this year a general consensus has formed that housing is bottoming. This was based on 4th quarter statistics that suggested inventory, sales and starts were stabilizing. On Friday, Alan Greenspan gave an upbeat assessment on housing during a speech here in Toronto and made the following comments:

The worst of the adjustment is over, meaning not that the market is turning, but that the rate of decline was at its maximum in the third quarter and continued over in the fourth quarter and should now be moving to a much less negative direction.

Regarding sub-prime mortgages:

We do have a problem here, it’s probably not over. It may actually infect some parts of the prime mortgage market, but there’s no real evidence that this is a significant issue.

I have a different opinion than the ‘Maestro’. I believe that the subprime market implosion will lead to another leg down for housing activity. To see why, consider that a decade ago subprime mortgages totaled a mere 2% of the entire mortgage market. Today they are one-sixth of all mortgages.

subprime_mortgages

The percentage of subprime delinquencies are at the highest level since 2002. Keep in mind that the subprime mortgage market is now four times bigger than it was then. And the delinquency rate is likely to head much higher.

About 80% of subprime mortgages today are adjustable-rate mortgages that have been nicknamed “exploding ARMs” because they have low fixed-interest payments in their first few years but then usually adjust to higher interest payments. It is estimated that around $1 trillion in adjustable-rate mortgages are due to reset over the next 2 years at much higher interest rates.

A study by the Center for Responsible Lending predicts that 20% of subprime mortgages made over the last 2 years, equivalent to 5% of total mortgages originated could go into foreclosure. This new supply of foreclosed homes dumped on the market would easily push down prices and curtail home building.

Moreover, there is increasing pressure on Capitol Hill to enact legislation sponsored by Barney Frank, the new chairman of the House of Financial Services Committee, designed to tighten up lending standards and disclosure rules. This could shut out 25% of potential subprime buyers from obtaining mortgages according to Merrill Lynch.

It is hard to imagine mortgage equity withdrawals (MEWs) continuing at the same pace as in recent years. Given that MEWs were a major source of household liquidity (as this graph by Calculated Risk depicts), consumer spending will have a tough time increasing.

Increasing foreclosures along with tighter lending standards for new borrowers is going to cause this housing downturn to be one of the worst ever, and likely to drag the economy into a recession.

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