Resident Fellow  Desmond Lachman

Your soothing editorial on the U.S. subprime mortgage market, "Subprime does not mean submerged" (March 17), overlooks two important considerations, which would suggest that today's turmoil in that market will spread to the wider economy.

First, in 2006 subprime lending constituted as much as 20 percent of all U.S. mortgage lending. In addition, other non-documented lending to borrowers with only marginally better credit ratings than subprime borrowers accounted for a further 13 percent of overall mortgage lending. With default rates rapidly rising and with 30 subprime lenders already having exited the market, it would be reasonable to expect that the present subprime turmoil could lead to a reduction in overall U.S. home sales of at least 10 per cent in 2007.

Second, the subprime turmoil is occurring at the same time that a host of other factors is exerting significant downward pressure on U.S. home prices. Mortgage lending standards are being tightened across the board, defaults on existing mortgages will result in the return of around 500,000 homes to an already saturated market over the next six months, around $500 billion in adjustable-rate mortgages are due to reset in 2007, and speculative positions in the housing market are starting to be unwound.

Should home prices at the national level indeed fall at an accelerating pace in 2007, one must expect that the overall U.S. economy will be materially affected. Lower housing activity would substantially crimp residential construction activity and employment. More important still, lower home prices could lead to strains in an over-leveraged financial system and could induce U.S. households to reduce consumption significantly in response to declining wealth levels.

Desmond Lachman is a resident fellow at AEI.