Sub-Prime Problems Will Likely Worsen

04/05/2007 12:00 am EST

Focus:

David Wyss

Adjunct Professor, Brown University

David Wyss, Standard & Poor's chief economist, describes how problems with sub-prime mortgages could spread. He now sees a one-third chance of recession in the United States this year, in part because of sub-prime's woes.

The falloff in the sub-prime lending market is significant, and we expect the weakness to last at least through the end of 2007. In the past two years, the sub-prime market accounted for about 20% of all mortgages and 40% of all adjustable-rate and interest-only home loans. S&P foresees losses of between 5.25% and 7.75% on 2006 sub-prime residential mortgage-backed securities portfolios.

That would be a record loss - the previous high was 5% in 2000. We do not see low interest rates or double-digit gains in home prices returning in the near term. Those factors might have allowed stretched sub-prime borrowers to refinance to a more manageable mortgage. Thus, we believe conditions in the sub-prime market will probably get worse before they get better.

The difficulties of sub-prime lenders affect the economy. Because there will be more foreclosed houses on the market, on top of the unsold homes held by individuals, new home construction should drop even more. In the second half of 2006, declines in residential construction activity reduced gross domestic product (GDP) growth by a full percentage point.

This pattern will likely hold through most of 2007, depressing GDP growth by a percentage point once again. This falloff in construction will also exacerbate the loss of income in the construction industry.

In recent years, home equity spending has been a major strength of the economy. Sub-prime defaults may change this to a degree, but higher interest rates and falling home prices will also be important. Last year, Americans borrowed $650 billion through home equity loans, second mortgages or cash-out mortgage refinancing.

With a weaker housing market and higher interest rates, this activity will almost certainly slow in 2007. More homeowners will be faced with the choice of borrowing from other sources or not borrowing at all. While those with strong credit may be able to borrow from alternative sources, many sub-prime borrowers could find those options closed to them.

Home improvement and educational expenses are the two major reasons consumers give for borrowing against their homes. The most immediate and noticeable damage will be to home improvement retailers, building materials companies, furniture makers and major appliance manufacturers, all of which might be expected to show some weakness in the coming year.

The pain in the financial sector from rising sub-prime defaults should be minimal at the major banks, because they have diversified income streams and because they were only a limited presence in this market. The financial players most affected, we think, will be stand-alone companies that specialize in sub-prime lending, along with a few major banks that had subsidiaries in the business.

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