Subprime fallout: worst yet to come

by Levi Folk | March 26, 2007

A credit squeeze is underway in the U.S. housing sector and that bodes negatively for equity investors. Housing market woes will continue to play out over the next year at least, and equity investments remain at the mercy of this force.

Higher interest rates were the catalyst for a purge in the excessive lending that dominated the mortgage market in recent years. Since the U.S. consumer was so reliant on rising house prices and mortgage refinancing to boost spending, the economy and equity markets are likely to suffer.

There is a line of causality running from the U.S. housing market all the way to the economy and the stock market, and that line is looking slack. The U.S. household has been the driving force of the U.S. economy in recent years, accounting for more than three quarters of GDP growth from 2004 to 2006 according to Lombard Street Research, while corporations have been holding back capital spending.

Homeowners have financed spending by taking equity out of their homes through mortgage refinancing, made possible by rising house prices and unfettered mortgage lending. Refinancing reached its peak at the start of 2005, but is no longer viable in the current environment of falling house prices. Just how lax were mortgage lending standards?

The reality is that millions of people who should not have had access to capital—and ordinarily would not—obtained mortgages. Consider the effects of loose lending standards courtesy of a recent Credit Suisse report:

Forty per cent of the U.S. mortgage market consisted of subprime and Alt-A rated (one better than subprime) borrowers, a rise from15% in prior years.

Most, in fact four-fifths of Alt-A borrowers, obtained low/no documentation loans in 2006.

The average combined loan-to-value ratio in 2006 was an aggressive 91%. Speculation in housing represented 18% of the market in 2005 and 2006.

These marginal lending practices are now creating serious indigestion for homeowners since the housing market ground to a halt. Housing starts and building permits are off nearly 30% from February, ’07, over the same month in ’06. Default rates are up in the subprime sector and they are due to rise higher for subprime and Alt-A borrowers, suggesting house prices will remain depressed for some time.

The worst is yet to come for mortgage lenders and, perhaps, the housing sector. Roughly US$300-billion of securitized subprime mortgages with adjustable rates (ARMs) are resetting to higher rates in 2007 alone, and the maximum impact of subprime resets happens at the end of the year. It is difficult to see how house prices can move higher from here, especially since lending practices will be tightened significantly.

Billions—make that hundreds of billions—of mortgages have been securitized and sold as collateralized debt obligations (CDOs) to investors. That has allowed the issuers of these mortgages in varying states of credit quality to take some risk off their books. CDOs had been a major source of demand with emphasis on the word had. The "CDO machine is wheezing," according to Grant’s Interest Rate Observer, and if this market dries up, it will undoubtedly just add to the tightness in U.S. housing.

Fed policy was a major contributing factor that led to the creation and subsequent fallout in U.S. housing. Mortgage lenders got a considerable boost when the Fed Funds rate was cut to 1% in 2003 and have since been undermined by a credit squeeze, also courtesy of the Fed, as rates were normalized to current levels of 5.25% (Of course, mortgage lenders lacked any sort of controls on lending).

The yield curve, the difference between the Fed Funds rate and the 10-year treasury yield, has been a reliable predictor of stock market weakness over the past two decades, and currently it is inverted, meaning short-term rates exceed bond yields, suggesting access to credit has tightened.

Monetary policy works with a lag, but it proves potent with patience. The yield curve inverted on four separate occasions (using a moving average) since 1988 and each time it coincided with or led a subsequent weakness in the stock market by several months. The last yield curve inversion, prior to the current one, was in 2000-01.

Perhaps the effects of tighter credit will not spread from housing to the broader economy. Thirteen per cent of ARMs, worth US$326-billion, are likely to end in foreclosure, according to Dr. Christopher Cagan, director of research at First American Core Logic, and total losses would amount to about one-third that amount -- admittedly small by U.S. economic standards.

A financial market crisis may not exactly be around the corner, but it is unclear what will take over from the housing market as the driver of U.S. economic growth. Corporations have been increasing borrowing to buy back their own shares rather than for capital spending. Dividends and share buybacks combined exceeded 100% of non-financial companies’ profits in 2006, according to London-based Smithers & Co. Ltd. Buybacks will boost earnings per share but will do so through fewer shares, not higher earnings.

So, as the U.S. housing market continues to grind down over the next year, the U.S. economy remains at risk. This could be the year that the U.S. consumer finally capitulates. That possibility looms large over U.S. equity returns.