Subprime Contagion?

Kash Mansori casts his vote in the debate about whether problems in the subprime mortgage market will spill over into other markets and cause problems for the overall economy:

Bad Loans, Banks, and the Coming Credit Crunch, by Kash: I've been thinking about the health of the banking sector of the US economy, and pulled together a couple of charts that have gotten me thinking. And worried.

First, take a look at this picture of the total quantity of loans outstanding at commercial banks in the US, broken down by type of loan.

The two things that strike me about this picture are 1) the obvious cyclicality of lending, particularly to businesses (more about that later); and 2) the incredible growth of real-estate lending over the past several years. Note that all series have been deflated by the CPI, and thus reflect real changes. Even after adjusting for inflation, real estate lending has nearly doubled since the start of 2000.

Now consider that the Mortgage Bankers Association (MBA) recently estimated that about 5% of all mortgages are currently in default, and that the delinquency rate that is growing rapidly. Suppose that we use that statistic to infer that 5% of commercial banks' real-estate loans will shortly have to be classified as non-performing. (Since commercial bank real-estate loans also include commercial real estate loans this estimate is a bit high, but since we know that the big growth in real-estate lending over the past several years has been for residential and not commercial property, the 5% figure at least makes a good starting point.)

That would imply about $170 billion in bad loans, or about 3% of the $6.1 trillion in total outstanding loans (real-estate plus non-real estate loans) on the books of commercial banks. Not all of that $170 bn will be lost to banks, since they should be able to foreclose and sell some of the underlying properties, but it seems safe to guess that banks will end up writing off some fraction of that total - probably many tens of billions of dollars worth of loans, or several tenths of a percent of all bank loans.

Now comes the scary part. Consider the following picture, which shows the rates of non-performing loans and loans that banks have had to write off over the past 19 years.

As of December 2006, both ratios were at comfortingly low levels. But the MBA data suggests that -- even if delinquency rate abruptly stops rising today -- we should expect the ratio of non-performing bank loans to rise by a few percentage points, and the portio of bank loans that banks are forced to write off to rise by some tenths of a percentage point. Those developments would quickly move the series in the graph above into the range where they were during the period 1990-92, when bad loans caused the massive Savings and Loan crisis and a widespread recession-causing (or at least recession-exacerbating) credit crunch through the US economy. (At this point, feel free to refer back to the top chart to see the effects of that credit crunch on business lending in the early 1990s.)

I hope it's now clear why I'm in the camp of those who are worried about the financial spillovers that the housing slump will have on the broader US economy.

Sticking with the topic of subprime mortgages, Robert Kuttner says there is a lesson to be learned from the collapse of this market:

The dangers of deregulation, by Robert Kuttner, Commentary, Boston Globe: The Bush administration and the US Chamber of Commerce picked an awkward moment for their latest assault on financial and consumer-protection regulation. At the very moment that Treasury Secretary Hank Paulson was meeting with Wall Street bigwigs in a high-profile confab this week to call for weakening of the post-Enron Sarbanes-Oxley Act and other investor and consumer protections, the stock market was tanking.

Why is the market so nervous? Mainly thanks to the latest bitter fruit of financial deregulation : the collapsing $1.3 trillion "subprime" mortgage business, which now accounts for one mortgage in three. Here is a textbook case of why financial institutions need to be regulated, to protect both consumers and the solvency of the larger economy.

In the past decade, as regulators discarded rules, shady mortgage banking companies, financed by the bluest-chip outfits on Wall Street, calculated that they could make a lot of money offering bait-and-switch mortgages to poor credit risks. Default and foreclosure rates would be greater, but higher profits would more than compensate for the risks. So the subprime mortgage industry, enabled by the big banks, invented amazing gimmicks. These included not just variable-rate mortgages, but mortgages that were initially interest only, mortgages with introductory teaser rates, mortgages with no down payment. No income verification required! No credit check! Subprime operators targeted people with horrific credit histories and families desperate for housing who could not afford the debt they were taking on. Last year, 60 percent of subprime loans required no meaningful documentation.

Then came the morning-after: As higher payments kicked in, people couldn't meet them. Defaults skyrocketed, to an estimated 13 percent of all such loans. At least 25 subprime lenders have gone out of business. The big dogs on Wall Street, who had invested in the subprime operators, took a big hit, too.

It's not clear where this will end. Many low-income families will lose their homes. Innocent investors will suffer the spillover effects on the stock market, and general mortgage rates may have to go up to compensate for these losses of reckless speculation.

But wait. Weren't these subprime lenders doing good works by making it easier for low-income borrowers to become homeowners? ... If the goal is to promote low-income homeownership, there are far better ways that don't put financial markets at risk and don't cause people to lose their homes after a few years.

For instance, the FHA has long had a program of insured loans that require only a 3 percent down payment (and have a much lower default rate). Non profit and public programs like Neighborhood Housing Services offer long-term help to moderate-income homebuyers on credit counseling. If we were serious about promoting first-time homeownership, we would offer subsidized, low-rate mortgages, as we did in the Great Society era, before Reagan and the Bushes gutted social spending. ...

Supposedly, the wizards of the private secondary mortgage market, such as Fannie Mae, vet the mortgages to make sure reasonable standards are being met. But Fannie has been reeling from her own scandals, and obviously someone was asleep at the switch. ...

Congress is ... investigating the entire mess, while mortgage industry lobbyists hope to fend off regulation by using the low-income family as poster child for the industry's misdeeds: Regulation would just hurt the poor.

But before the mid-1970s, this kind of meltdown didn't happen, because there were regulations and prudent credit standards; low-income people got government help rather than private-market scams -- and there were hardly any defaults. How many more financial scandals will it take before we get back to that model?

I don't want to go back that far, i.e. to the 1970s - it was too hard even for good credit risks to buy a house, but rethinking how these markets are regulated is clearly needed.