2007Apr Sub-Prime Goes Prime Time

2007Apr Sub-Prime Goes Prime Time

If you are like most Americans, chances are good that you had never heard of “sub-prime” financing until the past few weeks. Now, if news reports are to be believed, your financial future may well be at risk due to a “meltdown” in this mysterious sector of the financial markets. With all the media attention this subject has generated, it might be time to ask a couple questions, namely, “What exactly is happening,” and “Do I have anything to worry about?”

First of all, there is nothing inherently “bad” about sub-prime lending. People with less-than-perfect credit scores have legitimate and economically sensible reasons for taking out loans for home or auto purchases or even for entertainment, for that matter.

The “crisis” is a result of a combination of factors involving these kinds of loans in the mortgage market. First, due to the low interest rates and strong price appreciation in the housing market, lenders felt comfortable making loans to sub-prime borrowers. Second, to make financing terms more attractive to these borrowers, adjustable rate mortgages with low, short-term “teaser” rates were offered. With interest rates low and home prices rising, this was a winning combination.

The problem is, short-term rates have risen and home prices in many areas have actually fallen. The short-term “teaser” rates have expired, and now many homeowners have seen their monthly payments increase by several hundred dollars. Being “sub-prime” borrowers, many cannot afford the increased payments. Unfortunately, many of them cannot sell their home or refinance either because the value of the house has decreased. So, the thinking goes, millions of homeowners will begin to default on their mortgages in the coming months, which will flood the market with foreclosed home inventory, further drive down prices, and spill over into credit lending in other markets. But will this really happen? And if it does, will it kill the economy? We suspect that the crisis is once again overblown.

We are possibly on the verge of a wave of defaults that has been estimated to be between $100 billion and $300 billion. Sure, that sounds like a big number. But our economy, as measured by GDP, is over $13 trillion. Furthermore, our economy is largely based on consumer spending, which not even September 11, two wars, and two cataclysmic hurricanes have been able to slow down during this decade. When you consider that the $100 to $300 billion in mortgages might go into default, remember that it does not happen in a day. This is a process determined by when the loans were made, when the borrower got behind on payments, etc. This would be the amount of foreclosures expected over time, not all at one time.

We suspect that, while some borrowers will feel the pinch, economic life will more or less go on as usual. The spending power of the largest generation in history is robust enough to withstand even a sub-prime “meltdown.” However, we would imagine there are more than a few lenders who will think twice about making that next mortgage loan to a sub-prime borrower.