Editor's Note

03/22/2007 12:00 am EST

Focus:

Howard Gold

Founder & President, GoldenEgg Investing

US stocks have been rallying the last few days, and that's good news. It could mean the recent market correction has come to an end.

The correction, triggered by a 9% one-day selloff in the overpriced Shanghai Composite Index, has been fed by fears about credit problems in sub-prime mortgages, which are loans made to borrowers who don't qualify for conventional loans.

Rising defaults in the sub-prime market won't sink the economy by themselves. But they reflect bigger problems as the housing bubble continues to deflate. At the least, they're likely to cut US economic growth. And it only underscores, as I've written here before (click here), that investors must prepare for a very different market than what we've experienced over the last few years.

Sub-prime mortgages have accounted for a growing percentage of mortgage loans in recent years. Some $640 billion worth were issued last year, off slightly from 2005.  They account for roughly 14% of total outstanding mortgages of around $8.5 trillion, Lehman Brothers estimates.

"Alt A" loans are granted to borrowers who generally have better credit ratings than those who get sub-primes, but these loans have looser underwriting and require less documentation than conventional mortgages. They represent some 27% of outstanding mortgage loans, according to Bank of America.

Delinquencies-loans 60 days or more past due-in both categories have been rising quickly, although the rate remains only 1.5% of Alt-A loans. It may be as high as 14% for sub-prime loans. (Conventional mortgages on primary residences generally have default rates of around 2%.)

The problem is, as housing prices rose, lending standards loosened. Desperate borrowers and aggressive lenders made essentially a "don't ask, don't tell" deal: I won't ask what your income and credit rating is, and you won't tell me.

So, too many borrowers signed up for exotic loans-adjustable-rate loans with minuscule teaser rates; interest-only loans; option ARMs with negative amortization, piggyback loans, and other variants.

These loans had one thing in common: They helped borrowers buy houses they couldn't afford, and mortgage lenders had to know that, even if they convinced themselves otherwise. As long as housing prices kept rising-as we all knew they would, forever-who would be the wiser? And besides, all these lousy loans were being sold to hedge funds and big institutions in the secondary market, so no one would be hurt, right?

Well, now that home prices are actually falling in some markets and leveling off in others, this deal is being exposed as the devil's bargain it always was. And Mephistopheles is there, as usual, with his hand out, demanding his due.

As defaults rise, sub-prime lenders are biting the dust. The biggest, including New Century Financial and Accredited Home, are scrambling to stave off bankruptcy. Shares of Alt-A lender IndyMac Bancorp and mortgage giant Countrywide Financial (which does sub-prime and Alt-A loans), have plummeted. Major financial institutions like HSBC and GMAC also have been stung.

And things are likely to get worse as rates on nearly $1 trillion in outstanding mortgages adjust upward over the next two years. Lehman forecasts defaults could hit $300 billion and 1.5 million to 2 million US homes could face foreclosure.
 
Lehman calls the additional defaults "manageable" in the context of the larger mortgage market. And Tobin Smith, in Thursday's Gurus' Views and Strategies (click here), rightfully points out that the problems touch a very small portion of the market and that the vast majority of US homeowners are paying their bills.

But the housing boom contributed mightily to the economic recovery-not only in the hundreds of thousands of new jobs it created, but in sales of appliances, tile, faucets, rugs, sofas, dining room sets and plasma televisions to furnish all those new homes that so many people could not afford in the first place.

As that engine starts moving in reverse, the positive effects could begin to unravel.  An additional 1.5 million foreclosed homes dumped on an already weak housing market will likely depress prices, not support them. And economists at Goldman Sachs predict that more than a million housing-related jobs could disappear.

"The fuel that kept the housing market going is gone," says Professor Ed Leamer, director of the UCLA Anderson Forecast.

The recent retreat in homebuilders' stocks-after a nice rally from their lows-reflects this fear. And many of the gyrations in the financial markets in recent weeks have been spurred by the uncertainty of how far the sub-prime contagion will spread.

Will it cause an economic recession? I doubt it, since sub-prime is such a small part of the total mortgage market, and wealthier consumers seem to be driving a good deal of spending, anyway. It will probably reduce already slowing economic growth, and hasten the US market's move towards large growth stocks and away from smaller, cyclical shares.

But these things have a way of spreading beyond where even the smartest people expect them to go. In our conversation, Professor Leamer pointed out that of the eight previous housing booms since World War II, seven were followed by recessions.

And this boom was the biggest of them all.

Howard R. Gold
Editor-in-Chief
MoneyShow.com

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Howard R. Gold is editor-in-chief of MoneyShow.com. The opinions expressed here are his own and do not reflect the views of InterShow.

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