Feb. 12 (Bloomberg) -- It was bound to happen sooner or later, an out-of-the-blue reminder that the froth or the boom or the disconnect between prices and fundamentals in the housing market would have a financial after-shock.
HSBC Holdings Plc, Europe's biggest bank, dropped a small bomb last week when it announced that it was setting aside more money as a cushion against the accelerating pace of loan delinquencies. Yes, Virginia, subprime mortgages -- home loans to folks with a spotty credit history -- do carry some risk after all.
In addition to making those loans, HSBC bought packages of subprime and second-lien loans from other mortgage originators. It seems the best models HSBC's quants could design didn't adequately reflect the inherent risk in lending to deadbeats when house prices stop soaring.
Before folks could say, ``sell,'' New Century Financial Corp., the No. 2 subprime lender in the U.S., delivered its bad news, saying it would have to restate 2006 earnings because of an increase in loan-loss provisions. The stock lost 40 percent of its value.
Isolated examples? Probably not. Confined to the subprime market? Doubtful.
``There is no way the conditions that existed in the subprime market between borrowers and lenders weren't a multiple of what went wrong,'' said Michael Aronstein, chief investment strategist at Oscar Gruss & Co. ``The incentives are perverse. You're paid for volume, not for being a schoolmarm.''
Subprime loans carry rates 2 or 3 percentage points higher than those extended to prime borrowers. They accounted for about 20 percent of new mortgages last year and 13.5 percent of the total home loans outstanding, according to the Mortgage Bankers Association.
The issue isn't whether loans defined as risky carry risk; they do. The real question is whether the risk was priced correctly; whether rising delinquency rates on subprime loans, sometimes made without proper documentation, will spill over into the rest of the home-loan market; whether borrowers will default when teaser rates on adjustable-rate mortgages reset higher at a time when home prices are falling; and -- the big kahuna, the one that matters to the Federal Reserve -- whether any of the bad- loan problems will affect financial institutions' ability to lend.
In its January survey on bank lending practices, the Fed said that a net 15 percent of domestic banks reported tightening credit standards on residential mortgage loans over the past three months, the biggest net increase since the early 1990s. That was the last time banks were saddled with -- guess what? -- bad real-estate loans. More banks and thrifts failed in the early '90s than at any time since the Great Depression.
The Fed's survey also found that a net 37 percent of the banks reported weaker mortgage demand to purchase a home. (It's not clear based on the limitations of the survey whether weaker demand was a result of tighter standards.)
The ripple effects of the housing slowdown aren't confined to the financial sector, according to Asha Bangalore, an economist at the Northern Trust Corp. in Chicago.
``Production in housing-related industries has dropped sharply in the past year,'' she says. ``For example, production in furniture, household appliances and carpeting has fallen for five straight quarters.''
A reasonable person might conclude that layoffs in these industries will compound the declines in residential construction, Bangalore says.
``Housing and housing-related employment made up a little over 40 percent of all payroll employment from November 2001 to April 2005,'' she says. ``Employment in residential construction declined in nine out of the 10 months ended January 2007,'' with 104,000 jobs in residential specialty trade contracting lost since the February 2006 peak, according to the Bureau of Labor Statistics.
The residential job losses were more than offset by gains in non-residential contracting, the BLS said.
Falling employment in one sector of the economy or one region of the country is not an expansion killer in and of itself. The Southwest oil patch was depressed when oil prices slumped to $10 a barrel in 1986 even as the economy logged four more years of strong growth. The Northeast real-estate market was slower to recover from the 1990-1991 recession than other sectors.
The danger comes when the financial system is impaired, as it was in the early 1990s in the U.S. and during the 1990s and part of the current decade in Japan.
That's when the Fed would start to get concerned about the ramifications, which so far have been limited to a decline in the prices of subprime mortgage bonds and the stocks of mortgage lenders.
It's too soon to know the extent of the problem from all the option ARMs (the interest is optional, but the principal is not!). Only three years ago, former Fed Chairman Alan Greenspan said homeowners could have saved a heck of a lot of money had they opted for adjustable-rate mortgages during the past decade.
Ex post, that was good advice. Ex ante, it's not looking good.
``American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed- rate mortgage,'' Greenspan said in a speech to the Credit Union National Association in Washington.
Lenders took his advice. Borrowers jumped at the opportunity. Everyone may suffer the consequences.
(Caroline Baum, author of ``Just What I Said,'' is a columnist for Bloomberg News. The opinions expressed are her own.)
To contact the writer of this column: Caroline Baum in New York at. Last Updated: February 12, 2007 00:05 EST