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.

The Radicalism of the American Revolution

This is July 7, obviously a few days after the official Independence Day, but we are so taken with the following idea of America, that we do want to share it with you.

Happy Fourth of July! Happy Independence Day!

When I'm not writing Geranium Farm articles, I work for Haver Analytics, a leading vendor of economic databases sold over the Internet to economists and financial institutions in the US and numerous other countries. Our staff of database managers and technicians are a multi-national bunch of "20s-and-30s" who also are from the US and numerous other countries. In the last few months, two of our colleagues have left us to return nearer their families in Germany and Norway. As a going-away present, it occurred to me, I should give them something that talks about America. Ergo:

In 1993, Gordon Wood, Professor of History at Brown University, won the Pulitzer Prize for a book that puts the American Revolution in a different perspective. It's not about the war or the drafting of the Declaration of Independence, but about the dramatic social change that emerged from this Revolution. The orientation and organization of society shifted sharply from what had gone before, literally through all the history of civilization. Wood thus describes The Radicalism of the American Revolution*.

"After eighteenth-century Americans threw off their monarchical allegiance in 1776, they struggled to find new attachments befitting a republican people . . . . they eventually found democratic adhesives in the actual behavior of plain ordinary people . . . . To base a society on the commonplace behavior of ordinary people may be obvious and understandable to us today, but it was momentously radical in the long sweep of world history up to that time."

Any of us who've studied much world history can, I believe, realize the truth in this. Throughout the span of civilization, Western and Eastern, people from the ruler on down have been defined by their inherited "station in life": whose slave or serf are they versus who owed them service and tribute. The American Revolution unraveled this rigid structure. Class lines and professional divisions that had been carefully defined for generations were blurred and broken.

Repercussions are widespread, as indicated by titles of the book's chapters: "Loosening the Bands of Society", "The Assault on Aristocracy", "The Celebration of Commerce" and "Middle Class Order", among others. For the first time, labor and hard work could be viewed as inherently worthwhile and not simply a burdensome activity performed by the poor to provide goods and services for the rich. Trade was no longer looked down on by an elite, leisure class, who did no "work" because that was beneath them. Education became the province of almost anyone who wants to pursue it. The poor could rise above their initial lot, and, indeed, "middle class" became the center-post of the culture.

Clearly, this over-summarizes and over-simplifies. We, in fact, remain concerned about the poor and the weak, and with good reason. With the breakup of a formal hierarchy, not only can people climb, they might also fall. There is no societal patriarch now, whose role it is to take responsibility for those of lowly estate. Failure happens – even to the "best" of us, however that may be defined.

At the same time, as Wood lines out, we no longer have to micromanage the slightest interactions with virtually everyone in society: for example, we need not estimate how far down the street we are from some approaching person and doff our hats or bow at some specified distance depending on whether that person is the squire's footman or the squire himself. We can nod in respect or greeting to anyone we choose – or not nod at all.

We are not segregated by rank in society. For society as a whole, such segregation was a matter of course prior to the Revolution. But there were instances of blurred boundaries, of the mixing of people of varying ranks. In fact, the Early Christian Church is a prime example.

In the Sermon on the Mount, Jesus tells his listeners that they are the "salt of the earth". It's often pointed out about the Disciples that they included fishermen, a tax collector, an accountant: they were not from the educated, moneyed, upper Temple classes. The Apostle Paul was a tent maker and periodically he had to stop preaching and make tents to earn money for his travels. Work was not beneath Paul. Early house churches encompassed mixes of people: slave and free, rich and poor, men and women, all in the same group socializing and sharing a Meal on the Lord's Day. A place where they were free to be whoever they were in the company of others of differing social levels. But these were relatively small clusters of people who associated in this way, and many kept very quiet about their Church membership when they were in other settings.

Small, then, but a foretaste of what would emerge in America's process of unbundling itself not just from the King of England, but from a style of life that was millennia old.

Consequently, in the early nineteenth century, a common man born in the rural Carolina piedmont could become a general of the Army and later President of the United States. In our own time, the son of divorced parents in a little town in Arkansas could become Governor of that state and later President of the United States. The owner of a 5-and-10-cent store in that same state could get ideas about how to sell massive quantities of merchandise at low prices and proceed to build the largest retailing company in the world. Not from "proper" or "established" society, any of these, but they and multitudes more have been able to move out and up from their original positions to achieve far more than anyone might have ever imagined. It was indeed a radical development.

Happy Birthday, then Americans, you ordinary car mechanic Cubs fan, you Wall Street portfolio manager raising your son by yourself, you two supermarket workers pulling crazy shifts to keep your rapidly growing kids in clothes that fit. We recently attended a family gathering with these last two; other family members include an IT manager, a university administrator, the business administrator for a nonprofit. We know another family where the husband roots for the A's while the wife prefers the Giants. Other couples where one is a Republican and the other a Democrat. All of these situations – a mix of professions in the same family and allegiances differing between husband and wife, to say nothing of inter-religious and inter-racial marriages – would have been extremely rare under the hierarchical society of former times. More, like my two young colleagues at Haver Analytics, almost no one lives anywhere near the towns where they grew up.

Aaron Copland caught the spirit well: "Fanfare for the Common Man". And using themes from African American spirituals and Native American music, Anton Dvorak composed "The New World Symphony", a classic emerging out of everyday experience. Amen.

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*Wood, Gordon S. The Radicalism of the American Revolution. New York: Vintage Press. 1991. Available from VivaBooks. Just click on the title.