- Jan 20, 2006
- Reaction score
- New Orleans, LA/Cambridge, MA
The Economist said:Anxious investors had hoped that the worst was over in the suddenly skittish stockmarkets. No such luck. On Tuesday March 13th the three big American indices gave back nearly all the ground they had regained since bottoming on March 5th. The Dow, the NASDAQ and the S&P each fell by about 2%. On Wednesday markets in Asia and Europe followed them down. Lacklustre American retail spending figures in February added to the gloom. Some fear that a slowing housing market may finally mean a contraction in consumer spending. But in the main, the losses stemmed from more direct worries about the housing market.
The trouble started with New Century, which had become the nation’s second biggest lender to would-be homeowners with dodgy credit histories or little cash for a down payment. Such loans, known as “subprime” mortgages, typically carry interest rates at least 2-3% higher than conventional ones. This has been a booming business in America, but the slowdown in the housing market has pushed many such lenders into the red. Last month New Century said it would be restating its earnings, triggering investigations into how it has accounted for its bad loans.
Last week the company was forced to stop offering new loans because it could not obtain financing; its bankers say it has defaulted on payments. Lenders have not only cut off all credit lines, many also demanded accelerated repayment of outstanding loans—which New Century says it cannot make. If the rest of its lenders demand their money back New Century will be on the hook for roughly $8.4 billion. The New York Stock Exchange has suspended trading in the firm’s shares and has started proceedings to delist its stock, which last changed hands at $1.66 (down from a peak of $51.97 last May).
Others are in trouble too. Accredited Home Lenders, another subprime specialist, has seen its stock hammered. Like New Century, Accredited saw its profits destroyed by soaring default rates and falling demand for new loans. The firm is struggling to find new forms of finance: to a spooked Wall Street, its credit is no better than one of its deadbeat borrowers. The firm’s stock closed at $3.97 on Tuesday, after a plunge similar to New Century's. General Motors is shoring up its troubled, former, subprime lending unit to the tune of $1 billion.
The shakedown is hardly unexpected. When home prices soar, as they have in America for some years, subprime lending is a lucrative business. Borrowers who cannot make their mortgage payments can refinance at more attractive rates (since the appreciation in their home value makes the loan a better proposition for lenders). Or they can sell the house, pay off the bank, and pocket a little money. As America’s housing market rose, lenders began offering ever-more exotic loan forms to entice new entrants into the housing market: adjustable-rate loans with introductory “teaser” rates; interest only loans; even mortgages in which the minimum monthly payment was less than the accrued interest. Naturally, many of the borrowers attracted to these were people who could not afford a higher monthly payment. The Federal Reserve says that homeowners' financial obligations as a percentage of household income are now the highest they have been since the data were first collected
Now the introductory rates on these loans are resetting, and the deflating housing bubble is making it difficult to refinance. On Tuesday the Mortgage Bankers Association said that defaults are rising. All categories of loans are seeing some signs of growing financial distress among borrowers, but the trouble is concentrated in the subprime sector, especially for adjustable-rate subprime mortgages. The number of serious delinquencies, defined as loans that are 90 days overdue or in foreclosure, is also rising.
It is not only hapless borrowers and those in the subprime loan market who will suffer. Collateralised debt obligations (CDOs), which repackage various forms of debt and derivatives into securities with varying degrees of risk, may now be hit. CDO issuers divide the package of debt into tranches with varying degrees of risk. Many subprime loans have ended up as pieces of CDOs, and as default rates soar the damage may well spill over into the CDO market.
The ripples may spread further. Shares in Moody’s, the ratings agency, and McGraw-Hill, which owns rival agency Standard and Poor's, have both tumbled since February, as investors have grown less attracted by the business of rating securities based on subprime mortgages. Commercial mortgage backed securities (CMBS) have also been infected, although there is no obvious connection between overstretched residential borrowers and the markets for office and retail space. Treasury yields are falling as investors seek safer harbours.
What of the American economy? There could be a vicious cycle, as defaults and foreclosures dump houses on already saturated markets, forcing prices down further and leaving more overstretched homeowners with negative equity. Housing slowdowns drag down GDP growth in two ways: by slamming the brakes on the construction industry, and by making consumers feel poorer so they spend less. The confluence could shock the economy, especially when combined with contracting credit. Homeowners and investors will be braced for more bad news to come.