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Credit Market Analysis: Why the negative impact of the US subprime mortgage market may be exaggeratedCredit Market Analysis 16 March 2007
Why the negative impact of the US subprime mortgage market may be exaggerated
US mortgage delinquency rates at 4yr highs...
The media has become transfixed with the US subprime mortgage market recently, where mortgages are extended to borrowers with higher credit risk, i.e. with low credit scores. This market has grown rapidly in recent years, as unemployment has fallen and credit lending standards have eased.
However, according to data from the Mortgage Bankers Association, the subprime mortgage delinquency rate, where loans are past due, has increased to a 4-year high of 13.33% in the final quarter of 2006, compared with 12.56% in Q3 and 11.63% a year earlier. The rise was particularly marked in subprime adjustable-rate mortgages (ARMs), which are more sensitive to interest rate rises. Remember too that interest rates have been raised seventeen times from a low of 1% in mid-2004 to 5.25% presently.
However, there are several reasons why the rise in subprime delinquency rates will not necessarily spread directly to a broader slowdown in consumer spending and therefore US economic growth (see below). The greater risk, in our view, is the possibility of contagion effects, resulting in tighter bank lending standards, even to consumers with good credit histories, and in the spillover effect to other asset classes.
...but the direct impact on the US economy should
So why should the rise in subprime delinquency rates not necessarily spread directly to a broader slowdown in consumer spending?
Firstly, the subprime mortgage market represents only a small proportion of the total market, about
10%. Moreover, delinquency rates for prime mortgages remained low at 2.57% in Q4 and have risen much less than subprime mortgages in recent years. Chart a on the next page illustrates the total mortgage delinquency rates since 1972 and chart b shows the split between prime and subprime delinquency rates since 1998.
Secondly, given historically low interest rates and continued jobs growth, particularly in the buoyant service sector, households should continue to service their debts comfortably. Chart c shows that employment has risen by an average of 156,000 in the past three months, in line with trend growth, boosted by a buoyant service sector.
Thirdly, the massive rise in housing wealth in recent years should provide ample cushion against modest declines in house prices. According to S&P/ Case&Shiller data, house prices have fallen in nine of the twenty metropolitan areas they cover (see chart d). However, there is no firm evidence to suggest that subprime delinquency rates in these areas are particularly high.
Chart e on the next page plots metropolitan areas with above-average subprime delinquency rates (data taken from First American Loan Performance, as reported by Reuters on 14 March 2007) versus their respective latest annual house price inflation, according to official OFHEO data. Despite former Fed Chairman Greenspan's comments yesterday linking house prices and subprime mortgage problems, there seems to be little evidence of a strong negative correlation between house prices and subprime delinquency rates. Indeed, the relationship appears to be positive to neutral. At the aggregate level, we expect house prices to stabilize this year and begin to recover in 2008.
Overall, while previous episodes of higher mortgage delinquencies (prime and subprime) have tended to coincide with a downside in economic activity, we believe that consumers will be more resiliant this time, because employment growth in the service sector is expected to remain strong.
Main risk: spillover effects via tighter credit conditions and a general rise in risk aversion
A key risk for the household sector is if the problems in subprime mortgage loans, mostly originated outside the banking sector, spill over into a tightening of mortgage lending standards by banks in the prime market. The concern, specifically, is that risk aversion leads to an over tightening of general credit supply to the household sector (and one can extend this to the supply of credit to the business sector).
Indeed, the latest Fed Q4 senior loans survey revealed that a net 16% of banks reported tightening credit standards on residential mortgage loans, which was the highest level since the early 1990s, see chart f. However, total mortgage delinquency rates have remained below the previous peak in 2001.
Aside from the impact on liquidity from bank lending standards, the other key risk is a reduction of liquidity in the financial markets resulting from a general rise in risk aversion, essentially a contagion effect. This means that, as risk aversion rises, the use of the abundant levels of liquidity in the financial markets seen in recent years will fall back, resulting in lower equity prices, wider corporate spreads versus treasuries and possibly higher corporate default rates. We have already seen some evidence of this recently, see chart g.
However, we believe that the tightening of credit standards are precautionary, in case the quality of loans deteriorate significantly. With economic fundamentals remaining broadly strong for the household sector, we do not expect a broader 'credit crunch' to develop. Further, we could see delinquency rates stabilise towards the end of the year. Moreover, despite the risk of contagion, the financial markets have also responded effectively in recent months by reducing treasury yields and therefore mortgage rates, thus ensuring a sufficient supply of liquidity in the system and providing support to the housing market.
Overall, we believe that talk of higher subprime mortgage delinquency rates leading directly to weaker household consumption growth and overall economic growth in the US are exaggerated. The subprime market is a very small part of the total mortgage markets, consumers' balance sheets remain solid and households should be able to weather temporary falls in house prices, given the build-up of housing wealth in recent years. Further, metropolitan areas which have seen lower house prices recently do not appear to be the same areas which have high subprime delinquency rates. Instead, the greater risk is the contagion effects of higher subprime delinquency rates into other asset classes not directly related. Such a general repricing of risk could lead to higher corporate spreads and default rates, which we have already factored in to our macroeconomic forecasts. Further, banks have already reported tighter credit lending standards for traditional (mainly prime) mortgages and the risk is that they over tighten lending standards, leading to a credit crunch.
However, we expect the prime market to remain strong and delinquency rates may peak later this year. This potentially could lead to some interesting trading opportunities, as these trends become clearer over the course of the year ahead.
Hann-Ju Ho, Senior Economist
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* All data and charts are sourced to Lloyds TSB Corporate Markets Economic Research, Merrill Lynch, iTraxx, Reuters, Mortgage Bankers Association and Bloomberg.
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