Resident Fellow  Desmond Lachman

As subprime lending problems at Bear Sterns, the venerable Wall Street investment bank, now come to light, one has to be struck by the positive spin that market analysts continue to put on the looming problems in the US subprime mortgage market. More disturbing still is the seemingly sanguine attitude and policy passivity of the Federal Reserve in the face of the mortgage market's present unraveling.

For despite the Fed's recent sad experience in 2001 with the bursting of the equity price bubble, the Federal Reserve now remains more concerned with inflation moving out of its 1-2 percent comfort zone than with the real possibility of a subprime induced financial market meltdown. If it indeed turns out that the Fed was yet again late to begin easing monetary policy in the wake of the bursting of another asset price bubble, history will hardly judge the Fed kindly.

The real risk that the subprime mortgage market poses to the overall economy stems from the very size of that market. For while Bear Sterns might have needed to pump in around $3 billion to support its two ailing hedge funds, the overall amount of subprime mortgages outstanding has mushroomed over the past few years to a staggering $1.3 trillion. Looked at in another way, subprime mortgages now outstanding amount to over 10 percentage points of US GDP, which is far from the niche market that some Wall Street commentators would have us believe.

As the default rate on subprime mortgages rises, the market price of these mortgages has started to plummet. As an example, subprime mortgages issued as recently as 2006, which were trading at the start of the year at close to 100 cents on the dollar, are now trading at less than 60 cents. It has to be only a matter of time before these impaired valuations are eventually reflected in the prices of the collateralized debt obligations in which the subprime mortgages are widely held. And when they are so reflected, they could easily result in a write down of mortgage-backed securities held by financial institutions by at least $500 billion.

The Wall Street optimists are hopeful that the hemorrhaging in the subprime market will soon stop as the U.S. housing market stabilizes. At best, this view has to be characterized as another example of hope triumphing over experience. For the experience of past U.S. housing downturns would strongly suggest that we are nowhere near a housing market bottom. While it is true that U.S. housing starts have already fallen 30 percent from their cyclical peak, in the average post-war housing cycle downturn, housing starts have tended to decline by over 50 percent from peak to trough. By this yardstick, we still have ways to go before we reach bottom.

A very real risk to the U.S. financial sector overlooked by Wall Street analysts is that the present U.S. housing sector downturn might be more severe than the average post-war cycle. After all, the housing boom that preceded the present housing bust was much more extreme than the average housing upswing over the past sixty years. Indeed, between 2000 and 2006, housing prices at the national level increased by as much as 80 percent, which is around four times the increase experienced in an average post-war housing upswing. One would have thought that this fact alone would be raising red flags in the market about the likelihood that a bigger than average housing bust now will follow the bigger than average housing boom which preceded it.

Adding to the likelihood that a more severe than average U.S. housing bust is now in prospect is a constellation of forces presently working to constrain housing demand. In recent months, long term mortgage interest rates have risen by 60 basis points while regulators have begun to significantly tighten the earlier overly lax mortgage lending standards. As if that were not sufficient of a burden for the housing market, mortgage default rates are now running at around 90 percent above their year earlier levels, while around $500 billion in adjustable rate mortgages are due to reset in 2007 at significantly higher interest rates.

In a recent speech, Federal Reserve Chairman Ben Bernanke acknowledged that the present housing market downturn was likely to last longer than the Federal Reserve had earlier anticipated. However, despite Bear Sterns' present travails, he is yet to acknowledge the damage that a further weakening in the housing market might inflict on the overall US financial system.

Mr. Bernanke's seeming state of denial about the severity of the housing slump could prove to be a very costly economic policy mistake. For not only is it blinding him to the need for an early easing in interest rates that might soften the housing slump, it also raises the odds of a full blown credit crunch that will be difficult to stem with belated interest rate cuts.

Desmond Lachman is a resident fellow at AEI.