 "Photo: Tim Annett")
IBC: In the last five years, consumer spending fueled by home equity cash outs has exceeded their earnings. But greater leverage exposes them to risk if the value of all real estate falls. Banks, meanwhile, increased their mortgage holdings causing the boom that most Americans enjoyed. This, however, made them susceptible to mortgage defaults which were in fact inevitable. Shouldn't subprime defaults have occurred earlier when the real estate bubble burst?
Tim Annett (WSJ): It's impossible to say when any fallout from trouble in the subprime market "should" have happened. Unfortunately, you can't draw neat chains of causality in a complex market - if you could, there would be a lot of derivatives salespeople out there pumping gas or mowing lawns right now. What's more, any bursting of real-estate bubbles that may have taken place isn't strictly a subprime affair. There are plenty of buyers with solid credit out there who have been boxed out of the housing market by rising prices. So, I don't think you can draw a line that says because X happened in the real estate market, then Y would happen at this time in this one segment.
IBC: The American public have always seen real estate as far more appreciative than stocks or mutual fund holdings. This belief was further strengthened when low income earners with a less than stellar credit score got into the market for mostly real estate properties. With an increase in the construction of new homes and declining figures in the purchases of existing ones, where is the market for subprime lending heading?
TA: Credit standards will inevitably tighten up. Some banks have already said that they are taking a second look at their mortgage lending requirements in light of all this. I suspect that like any market, the subprime market will ebb for a time, but as long as there are people with less than sterling credit out there who want to buy a home and as long as there are banks willing to lend them money, then the market will survive. Junk bonds survived Michael Milken, derivatives survived Orange County, hedge funds survived Long Term Capital Management and subprime mortgages will survive New Century Financial.
IBC: Owing to an increase in subprime defaults, lenders have fallen out of business - some even bankrupt. However, subprime lending constitutes only 20 percent of the entire lending market. According to CNBC, 87 percent of subprime borrowers are up to date on their loan payments are the figures telling us that the entire lending market cannot survive on a subprime default of 13 percent?
TA: No. The banks that were lenders to the busted subprime shops are still lending out money and most banks have reported very strong earnings over the last week or so, suggesting that the subprime problem isn't having a huge impact on their business - at least, not yet. But the subprime fiasco isn't going to bring the entire business of making loans to its knees.
IBC: Most discussions on the subprime market are surrounded around credit policy tightening, but we also have concerns about the huge blocks of loans coming into reset this year. What is your take on that?
TA: The two go hand-in-hand. What lenders and regulators do in response to the current problems will have an impact on those future resets?
IBC: Late last year, states like Ohio passed legislative restrictions on predatory lending which results in low liquidity on the mortgage lending market - liquidity that was at the origination of the housing boom. What impact will that have on the market if the same strategy is implemented at the federal level?
TA: Again, it's impossible to say. What happens with the current subprime tangle will help to dictate the political outcomes on the federal level. If the market wobbles but keeps its feet, it may be that Washington doesn't do anything. And it seems that federal banking regulators are pushing banks and subprime borrowers to work out solutions to delinquency matters in a way that avoids a huge wave of foreclosures and what have you. But if borrowers and lenders can't play nicely, regulators may decide that they need more adult supervision. It's hard to game out just what might happen from a legislative standpoint since there is still so much uncertainty surrounding the market.
IBC: Singling out the current situation on the subprime market, what is your expectation of its impact on the overall market and the economy as a whole?
TA: If things continue on their present course I suspect that the impact will be minimal. But that's a sizable "if." We don't really know what's lurking around the next bend in the road when it comes to subprime mortgages.
IBC: Taking into concerns all other factors, and in inclusion the housing market, what's your expectation on the outcome of the Fed's meeting and where do you see rates heading?
TA: Futures markets have pretty much backed out any chance that the Fed will move rates in any direction for the remainder of the year and given what we currently know about the Fed and the economy, it seems that is the correct view.
Special thanks to Tim Annett for his willingness to contribute to this report.
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