Resident Fellow Desmond Lachman

Hope springs eternal on Wall Street. For despite short-lived periodic concerns about the US sub-prime mortgage lending fiasco, Wall Street analysts almost uniformly put a positive spin on the present unraveling of the US housing market. By so doing, not only do they downplay the housing market bust’s likely overall macro-economic consequences. They also give one an eerie feeling of déjà vu. Were not many of those same Wall Street analysts assuring us in 2001 that there would be little macroeconomic fallout from the bursting of the dot.com equity bubble only to have to backtrack on those assurances as the year progressed?

In downplaying the seriousness of the present deepening of the mortgage market crisis, Wall Street analysts are generally making two points. First, they are arguing that sub-prime lending is a relatively small part of the US mortgage market with limited significance for the overall US economy. Second, they are arguing that even in the sub-prime mortgage market space, the problems will be contained since the US housing market is now in the process of stabilizing. Sadly these analysts would appear to be very wrong on both counts, which has to explain why they are overly sanguine about the potential impact of the housing market’s present woes on the overall US economy.

Far from being a niche market, the US sub-prime mortgage market has attained major proportions over the past several years. It has done so as overall mortgage regulatory oversight was being relaxed and as an increased proportion of US mortgage lending was being securitized. By 2006, sub-prime mortgage lending accounted for as much as 20 percent of overall mortgage lending. As a result, the amount of sub-prime mortgages outstanding presently totals as much as US$1.3 trillion, or the equivalent of 10 percentage points of US GDP. Further complicating matters is the fact that there is presently an additional US$1 trillion outstanding in Alt-A mortgage loans, which are mortgages to borrowers with only a marginally better credit rating than those who borrow in the sub-prime mortgage market.

The troubling aspect of the past orgy of sub-prime mortgage market lending is that it could result in very meaningful losses for the US financial system that in turn could make US banks more reluctant to extend credit in general. The real danger of such a credit crunch is underlined by the fact that most sub-prime lending was made without income or asset verification and was made with unusually high loan-to-home value ratios. In the event that sub-prime lending was in the end to be written down by 20 percent, one could be looking at overall losses for the US financial system of anywhere up to US$250 billion. Were that to occur, the overall cost of the present US sub-prime lending crisis would exceed by a wide margin the cost of the 1981 savings and loans crisis.

The Wall Street optimists assure us that we have most likely seen the worst of the sub-prime mortgage crisis since they claim that the US housing market is now showing signs of stabilizing. In making that assertion, they happily overlook the presently very saturated state of the US housing market as indicated by historically high vacancy rates and a rapidly rising inventory of unsold homes. They also overlook the fact that housing supply is now almost certain to be substantially boosted by the increasing number of housing foreclosures already underway and by an unwinding of large speculative positions in the housing market.

More serious still perhaps is the downplaying of the series of factors presently in evidence that will be conspiring to substantially undermine housing demand in the months ahead. Among the more troubling of those factors are the recent 50 basis point back-up in long term interest rates over the past few months, the belated tightening of regulatory mortgage lending standards now underway, and the scheduled rise in the pace at which adjustable rate mortgages reset from around US$25 billion a month at present to almost US$50 billion a month by year-end.

As the US housing market crisis deepens in the months ahead, fingers will be pointed at those who might have contributed to the earlier housing bubble. What was the Federal Reserve thinking a few years ago when it was encouraging the use of adjustable rate mortgages and the development of the sub-prime mortgage market? Why have the rating agencies been so slow in downgrading sub-prime mortgages and in failing to protect less informed investors? Were the investment-banks behaving responsibly in originating mortgage loans in large quantities that they must have known were unlikely to perform in short order?

In this process of apportioning blame, questions should also be asked of the Wall Street analysts. Why did they keep on their rose tinted spectacles long after it should have been clear that the US housing market was to experience its worst downturn in the post-war period.

Desmond Lachman is a resident fellow at AEI.