Several months ago I finally broke down and got an online subscription to the Wall Street Journal and Barron's. For those of you who are unfamiliar, Barron's is a weekly financial publication that provides interviews, market analysis and editorials. This week they have a follow-up interview with Sy Jacobs, who first predicted the subprime mortgage problems in 2005. Below are excerpts from his interview (subscription required).
Some insist the problems in the subprime market are manageable.
The problems in subprime are not self-contained. It is a pinprick to a larger problem, and it needs to be looked at that way. The notion that subprime home-equity lending is somehow ring-fenced because it is only 12% of total mortgage loans outstanding and won't affect the rest of the mortgage and housing market is absurd. First of all, subprime lending was over 20% of 2006's volume. That tells you it was growing rapidly as a percentage of the mortgage business when it hit the wall.
The common argument coming from people against the subprime problem spreading is the subprime market is only "12% of the current market". Jacobs points out that in fact last year subprime mortgages were 20% of total mortgage underwriting. This means that a larger percentage of total mortgages sold last year were of lower quality. And this does not include the alt-A loans, which are above subprime quality but below prime credit quality. In other words, there are more problem loans out there than the 12% figure gives credit for.
How will the problems spread?
Mostly through housing. This year is going to be much worse than 2006 for mortgage and housing credit, and 2006 already laid the mortgage industry low. Nearly $700 billion of mortgages reset this year and nearly half of that is subprime. Remember 2004, when our esteemed former Federal Reserve chairman, Alan Greenspan, was exhorting us to take out adjustable-rate mortgages, the federal-funds rate was only 1% and had nowhere to go but up? Prime refinancing volume peaked in 2004, and the most popular loan product at that time was a 3/1 adjustable-rate mortgage, three years fixed and adjustable every year after that. Those are resetting this year after 17 quarter-point increases in the fed-funds rate. The subprime home-equity market peaked in 2005, and the most popular product from that year was a two-year-fixed, 28-year-floating mortgage. It resets this year, and now credit spreads are widening, Freddie Mac [ticker: FRE] is going to stop buying as much subprime, as are the capital markets in general, and a lot of capacity is exiting through bankruptcy courts.
First, I have seen to total amount of resetting mortgages this year at totals that range from $500 billion to a $1 trillion. That means we don't know how many are actually out there, but there are a ton of them that will reset this year.
Also notice that when people bought these loans, interest rates were incredibly low -- probably the lowest rates we'll see in out lifetime. Interest rates (The Fed Funds rate) have increased 4.25% since most of those loans were sold. That means a lot of borrowers are going to be in for some serious sticker shock.
Here is how the problem will spread through the housing market.
How bad is the credit crunch?
It is spilling into the secondary market in the sense that credit spreads in the secondary market have widened in the past few weeks. We're seeing a reversal in the appetite for risk that we've seen for the past several years. Credit will get more expensive across asset classes, and that's another way in which the subprime contagion will spread.
Let's back up through the eco-talk.
1.) "Credit spreads are increasing." OK -- here's what this mean. Interest rate products (bonds and loans) are measured against the US Treasury curve. Prices are quoted as "spread to the Treasury."
As the risk of a particular asset increases people sell that asset. Prices and yields move inversely; as prices drop, yields increase. To wrap this all up, as prices for mortgage-related products have dropped, their respective interest rates have increased. This means these products are now more expensive for borrowers because borrowing costs have increased.
Increasing interest rates obviously dries credit up because fewer people are willing to take out a loan at a higher interest rate.
2.) Credit standards are already tightening. That means the amount of subprime mortgage loans will decrease. While this is a good thing in the long run, it will act to decrease the number of potential buyers. This will act to lower home prices.
3.) As the number of subprime mortgage foreclosures increase housing inventory will increase. As I noted yesterday on my blog, the total number of existing homes in the for sale inventory has only decreased about 3% since last July. That means there are still a ton of homes on the market. And as foreclosures increase, the number of existing homes for sale will increase. This will add further downward pressure on prices.
So to sum up:
Tighter credit standards = fewer buyers = lower prices.
More foreclosures = more inventory = lower prices.
Update [2007-3-24 10:5:0 by bonddad]:: The Blog Calculated Risk has a great article on the housing supply and demand imbalance titled: "Housing: Supply Demand Imbalance". He explains the above points very well.