The Stock Market, Subprime Mortgages and Risk

Last week, the stock market fell 4.2%, measured by the Dow Joes Industrial Average, 586 points from 13,851 to 13,265. Just on July 19, this widely followed Blue Chip barometer had pierced 14,000, an all-time high.

We last talked about stock prices here in February, when they fell more than 400 points in a single day. That move was mainly a reaction to a sudden downdraft in the Chinese market. No sooner was the ink dry on our article – so to speak – than US stocks turned back higher. The Chinese market may have hiccupped but that didn't mean there was anything fundamentally different about the Chinese economy, which continued to expand at a double-digit pace in the second quarter of 2007.

Risky Mortgages = Risky Stocks
The current move in US stocks may reflect something more substantive in US financial markets generally. We've hinted for some time now about our concern with subprime mortgage lending and with consumer borrowing in general. We felt stumped though in talking about these subprime loans because we weren't sure how they would fit into the Geranium Farm setting. Probably few of you have one of these. A regular loan on your house, yes, but I'm guessing few of you are in a high-risk category. Now the light has dawned and we see the link between you readers and other people's subprime mortgages, and it's a pretty direct one at that.

Subprime mortgages have been a major vulnerability for financial markets in the last couple of years, as they have expanded greatly. Sure enough, their riskier borrowers default more often, starting a chain of losses among lenders and investors, which can spill over into other sectors. So we'll describe these loans here and then talk more about mortgages in general. The biggest drops in stocks last week came when one of the nation's leading lenders, Countrywide, reported a hit to its earnings because defaults are increasing not just on its subprime loans but on its regular mortgages now too.

Subprime Borrowers "Not Ready for Prime Time"
Subprime loans reach people who've never had much experience with credit. These borrowers are often young, first-time homebuyers who have only recently joined the workforce; they may not have much saved for a down-payment. They are older buyers who've fallen on hard times and have poor credit. They are minorities who've frequently been shut out of the market for housing credit. These people all pay higher interest rates than regular borrowers, but they have access to the credit now. Well-meaning regulators want banks and mortgage companies to serve these people because – as you would understand too – people who own their homes take better care of them and are more active citizens in their communities. The lenders are able to extend these loans because they have more sophisticated techniques for analyzing people's credit, the now familiar "credit score", and broader investor sources for the funds they lend. Individual mortgages are pooled together and sold as a group to investors all over the US and in other countries. The investors who buy these mortgage bonds like the higher interest and are able to shoulder the greater risk – up to a point.

And Lenders Who Got Carried Away
Part of the problem with this arrangement is that it began in about 2004 very profitably for the lenders and they got carried away with it; in 2005 and 2006, they became increasingly liberal in the borrowers they made loans to. Sometimes, in the extreme case, little or no background checking was done. Also, apparently, little education was provided to the borrowers so they would understand the force of the commitment they were making and its weight on their household finances. Some defaulted on payments within just a few months of taking out the loan. Others who had adjustable rate mortgages started with a low initial interest rate and then saw their rate and their payment rise dramatically six or 12 months into the term. Some of these rates "reset" more frequently. So delinquencies and foreclosures rose too, very dramatically.

In describing this, we don't want to overplay its broader impact. These loans are a small proportion of the total mortgage market, 13% of 43.9 million mortgages outstanding at the end of March. And the vast majority of them – more than 85% - were current in their payments at that time.

Is Risk Spreading?
Regular, prime mortgages have been in fairly good condition. Industry-wide data through the first quarter of this year even showed some reduction in that period in the proportion that were delinquent in payments, although foreclosures were rising. But higher interest rates have affected more and more of these loans even as house prices have been falling. And the rising price of energy has hit everyone with higher heating, cooling and other maintenance costs.

So risk has increased in US financial markets and investors of all kinds moved their money last week to what they regard as safer assets, especially US Treasury securities. Ironically, in this, the US dollar firmed in foreign exchange markets. Rather than setting off a rush out of dollar assets, the mortgage and stock market distress prompted investors to bring some funds invested abroad back to "home base", where they were more comfortable.

Trouble So Far Seems Confined to Housing; Stocks Regroup Today
Where does the market go from here, you may want to ask. What we saw already in today's trading was some recovery in stocks, which finished up about 90 points on the Dow, or 0.7%, and a bit more percentage-wise in other indexes. An important factor presently, unlike many periods of correction, is that economic fundamentals remain fairly healthy and money is not tight. Interest rates went up during the spring and lending standards have been raised in recent months, but funds remain available for quality borrowers and for investors to put to work. As stock prices went down last week, nimble investors still had funds they could put into higher-rated bonds, whose prices went up. If money is tight, there would likely be a general contraction in all kinds of financial asset values, adding more concern about widespread economic fallout. This is not the case now. Further, companies continue to earn profits. Midst the market disruptions last week, Ford, of all firms (one we've discussed: see Ways of the World, September 25, 2006) reported an outright profit in the second quarter, its first in two years. Other nonfinancial firms are also reporting favorable financial results. The resiliency of the economy in the face of surging energy costs and falling home prices is surprising; it is holding up better than we'd have expected.

We'll stop here today, but hopefully you see the mix of factors: greater risk in a major sector of the economy, housing and mortgage borrowing, but generally good conditions elsewhere. So financial market volatility increases and investors rearrange their holdings. But so far, spill-over effects have been limited. Keep your fingers crossed!

Subprime Loans, Used with Caution, Are Beneficial After All
Oh, and one more comment about subprime loans. We complain here about lenders who got carried away. But this is not a reason to withdraw this kind of credit altogether. We just need to be more sensible about it. In general, it is very beneficial, and we are sure there are lots of new homeowners out there who would agree enthusiastically.