March 26, 2007

The boogey-man of the month for stock investors had been a one-day slide in the Chinese stock market of nearly 9% (there’s been a meaningful retracement since then).  But more recently a new monster reared its head in the form of subprime mortgages.  The word “subprime’ is certainly en vogue – I don’t have a good base of comparison, but if you “Google” the word you get 8,450,000 responses (up from 639,000 responses in mid-March).  It seems as if that is how frequently I hear the term on CNBC on a daily basis.  So, of course, one has to wonder if so much attention is being given to this topic by the masses, is the worst behind us?   Or will there be a contagion that affects the stock market?

First, a quick definition of what we are talking about, I’ll just copy-and-paste an explanation from one of those aforementioned websites:  “A subprime borrower is one who cannot qualify for prime financing terms but can qualify for subprime financing terms. The failure to qualify for prime financing is due primarily to low credit scores.”  As such, a subprime mortgage is simply a mortgage that is backed by someone with a greater likelihood of defaulting on the loan, relative to “regular” loans. 

How did we get into this situation?  I’ll get into more details later, but the bottom line is that as the housing market boomed, lenders loosened restrictions on to whom they gave loans.  Delinquency rates on subprime mortgages have already spiked and credit spreads on subprime vs. prime mortgages have widened from 250 basis points to 1,400 basis points (which is the market’s way of showing that risk is growing for sub-primes). 

To rephrase, banks simply misjudged the default risk of lending.  The consensus seems to be that lending guidelines will revert back to where they were four years ago (those guidelines would have disallowed about a quarter of last year’s approved loans unless more money was put down).  And that is good news in terms of putting the brakes on something that many fear will snowball into something worse.  Historically, about twenty percent of the loans in the subprime market cause more than half the corporate losses, so an early reaction will limit any big earnings fallouts (except, of course, for the riskiest and least diversified of lenders – per the Financial Times, more than twenty five of which have already “closed their doors” since late last year).

Obviously that greatly affects the lenders, but the earlier question still remains – will there be a contagion that affects the stock market?  The stock market would remain at risk if there were enough delinquencies and/or defaults by submprime borrowers because of the affects on consumer spending and economic growth as well as earnings of the mortgage lenders.

Part of the problem in assessing potential damage is that we just don’t know how much risk is out there.  It turns out that there are no good predictive tools on delinquencies and how many delinquencies turn to defaults – at least not for the way loans were handed out for this cycle.  For example, lenders typically use FICO scores to measure the creditworthiness of borrowers. These scores are used to determine if a loan should be given under what parameters, and what is the probability of default.  But FICO scores have not been used for predictive purposes for subprime loans during a weakening housing market (and especially not for the second and third mortgages that so many people used as cash machines in the last few years).  We know, for example, that about thirteen percent of all submpime loan payments are at least 60-days overdue, but we do not know how to extrapolate that given the easing of lending standards over the last few years.

But we do know that the so-called  “Alt-A” segment of this market (mortgagers whom were granted no-documentation loans because they had slightly better credit ratings than the worst of the bunch – i.e. not the very bottom FICO-scorers) is running defaults at four times the historical rate.  That’s bad news because it shows that the contagion is spreading to higher quality loans. 

Add to that the new record amount of no-or-low money down on houses and the huge amount of new home owners that simply didn’t understand the risk of adjustable rate mortgages (ARMs), there is not a good tool for predicting how bad this could get.  Lenders got far too aggressive by historical norms in lowering credit standards and pricing loans.  This year and next could be difficult for ARMs holders that originated their loans in 2005 and 2006 and reset after two years – Fitch Ratings estimates that monthly payments could jump as much as $500 for some of these holders.  An estimated $600 billion of ARMs – two-thirds of which are subprime – are scheduled to reset in 2007. 

Then there is a less obvious ripple affect.  Lenders are now tightening lending standards, perhaps making (at least for now) no-and-low down payment as well as stretched mortgages (some to the tune of 40-50 years to lower monthly payments) a thing of the past (or at least much less accessible).  This will cool demand in the housing market which has been a great contributor to the US economy in recent years – the transactions have helped boost GDP as well as boost job creation, especially in the form of real estate agents.  But even if there is a net-negative affect, don’t expect the market to tank – loans are still easily accessible for folks with good credit.  But at the low end it is widely thought that home demand will slow at a noticeable clip (but think five-percent, not fifty).

Evidencing the stifling of any ripple affect, according to the publication Asset Backed Alert about $40 billion of home-equity loans and subprime mortgage transactions had been priced in the first two months of this year, down from $85 billion over the same period last year.  Lenders are becoming more cautious.  Still, the concern is that the latest wave of problems for subprime lenders could spread to the rest of the $8 billion mortgage industry.  And data from the Mortgage Banker’s Association suggests that some amount of fear is reasonable.  According to MBA the rate of late payments and defaults on US home loans hit 4.95% in the fourth quarter, up from 4.67% in the previous quarter.  That problem was largely concentrated in the subprime market (14.4% up from 13.2%).

It is far from certain how the subprime woes will affect the broader housing market, the economy, and by logical extension, the stock market.  The housing downturn is likely not over, and this is already after many Americans have already felt a great deal of pain.  The worst case scenario is that a recession is triggered   Is that likely?   Former Fed Chairman Alan Greenspan suggests that there is a 33% chance of a recession by the end of 2007.  And me?  I’m a little more optimistic, but I still give it a 20% chance.