Weak Housing Threatens to Slow Economy

Both borrowers and lenders in the sub-prime mortgage market are wishing they had heeded Polonius’s advice — neither a borrower nor a lender be.

Last year lenders made $605 billion in mortgages available to people with poor credit. Those borrowers, who account for about 20% of the home-loan market, include couples with comfortable incomes but who cannot meet the mortgage payments on the too-expensive homes they bought, and low-income buyers who sometimes cannot even meet the first monthly payment. Lenders include the likes of HSBC, which may be out of pocket to the tune of almost $7 billion.

There is blame enough to go round. Lenders, attracted by the 2-3 percentage point premium they could charge, and believing themselves protected in the event of default by rising house prices, offered no-downpayment, no-income-verification loans, known as “liar loans”, to people with chequered credit histories. Borrowers closed their eyes to the fact that interest rates would rise after an initial “teaser” period.

One result is that delinquency rates on sub-prime mortgages topped 14% last year, a record. Another is that the problems in this market threaten to spread to the rest of the mortgage market, choking off the flow of credit to the shrinking band of consumers still interested in buying a home.

Never one to allow the market to sort things out, Congress is calling for regulation of the sub-prime market. These are the same legislators who forced banks to make loans to inner-city borrowers, and who were enthusiastic about the way in which sub-prime lending encouraged the spread of home ownership to lower-income constituents. They now claim that the borrowers were duped by lenders who did not inform them adequately that their incomes were too low to service the mortgages they were seeking.

The banks, meanwhile, are trying to hand these troubled mortgages back to the lenders who originated them, before selling them on to the banks. Without much success, since the loan originators simply don’t have the cash to honour their commitments. More than two dozen mortgage lenders have closed down in recent months, and 100 more are expected to follow suit.

Most important of all is the effect that this collapse of the sub-prime market might have on the American economy. Thirty-two of the 58 economists responding to a survey by The Wall Street Journal expect the problems in the sub-prime market to spread to the broader mortgage market as lenders get skittish and tighten their lending standards. But the majority believe even this will not prevent the economy from reaching a 3% annual growth rate by the end of this year.

The economists seem to be cheerier than the many investors who dumped shares when the woes of the sub-prime market were revealed. These bears fear a liquidity shortage as regulators tighten lending standards. The tremors are already being felt in what is called the Alt-A market, designed for borrowers who are better than sub-prime risks but not as a sound as prime borrowers. It turns out that 80% of all Alt-A loans last year were of the no or low-documentation variety, perhaps best described as fibber loans.

One respected adviser, impressed by “truly horrific anecdotal evidence” from the housing market, tells me, “be worried, be really worried”. Even prime borrowers, he says, will feel the pinch when the low teaser rates in their adjustable-rate mortgages start to rise — just as the values of their homes start to decline at an accelerating rate. Worse still, holders of conventional fixed-rate mortgages will find that harder-nosed lenders are less willing to let them extract equity from the value of homes that are no longer racking up large price increases. That is a sure prescription for an outbreak of consumer fright, a zipping of wallets and, as a consequence, a recession, exacerbated if lenders screw down on other borrowers.

Even if the prime market is unaffected, the problems in the sub-prime and Alt-A markets will hit the economy hard by pushing back any recovery in home construction. Some 40% of homes sold last year were to borrowers in those less-than-prime categories. Experts guess that about half of such borrowers will now be turned away, unable to get mortgages. This means that 20% of the demand for homes has been obliterated just when repossessed properties are adding to inventories — surely an indication that the economy will tip into recession by year-end.

Possible, but not likely. According to the latest data, 33% of all homes in America are owned free of any mortgage, and another 57% carry traditional, fixed-rate mortgages. At the time of the survey, 2005, adjustable-rate mortgages accounted for only 10% of all mortgages (that figure has probably risen since the survey was done).

So, housing will remain weak; less-than-prime borrowers will find the credit window closed; people with adjustable-rate mortgages will have to shop less so they can meet higher payments; tighter lending standards and falling home prices will reduce consumers’ ability to tap the equity in their homes.

But so long as the job market remains strong, which it has done even though some 100,000 workers in housing-related industries have been laid off, and so long as real incomes continue to rise, consumers might grumble, but they are unlikely to go on a buyers’ strike on a scale that will convert slowdown into recession. So don’t be very worried. But don’t relax completely: even Ben Bernanke, the Federal Reserve chairman, is now watching incoming data with a bit more apprehension than just a few months ago.