The news about the U.S. subprime mortgage loan meltdown just keeps getting worse. The Center for Responsible Lending analyzed more than 6 million subprime mortgages issued from 1998 through the third quarter of 2006 and found that "2.2 million households in the subprime market either have lost their homes to foreclosure or hold subprime mortgages that will fail over the next several years." New Century Financial, the largest independent U.S. subprime mortgage lender, filed for bankruptcy, and 3,200 people -- about half the company's workforce -- lost their jobs. Numerous other subprime lenders have closed their doors, and others are sure to follow.
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The Mortgage Bankers Association reports that the seasonally adjusted rate of loans entering the foreclosure process was at an all-time high in the last quarter of 2006, and "increases in delinquency and foreclosure rates were noticeably higher for subprime loans." And the National Association of Realtors reports that total existing home sales in April were 10.7% below those of a year ago, attributing the drop to the fact that many subprime loan products are no longer available.
But cheer up! The Dow continues to reach new record highs, far surpassing the 13,000 mark, right? And people who don't have a subprime loan or work for a subprime loan lender don't have any skin in the game, do they? Besides, the subprime debacle will be contained, won't it?
Federal Reserve Board Chairman Ben Bernanke believes the overall economy can withstand the problems in the subprime lending market, stating in a speech in Chicago, "The effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system."
Not so fast, says Dennis Jacobe, Gallup's chief economist. The subprime crisis likely will affect everybody eventually. The reverberations will be subtle in some ways and overt in other ways. And it won't be over any time soon. In this interview, Dr. Jacobe discusses why the subprime loan market imploded, what effect this will have on credit and the economy, and whether you or your grandchildren will sell your house for more than you paid for it.
GMJ: Subprime loans are generally made to people with poor credit histories. But there can't be all that many subprime borrowers. So why is there such a big ripple effect?
Dr. Jacobe: About 20% of the loans made last year were subprime. Probably another 20% to 30% involved creative refinancing, such as adjustable-rate loans that require borrowers to pay enough to cover the monthly payment for the first number of years, then the mortgage rate is scheduled to go up each year. Or they are "buy down" loans, which are the same kind of thing, but at a fixed rate: The first several years are at an artificially low rate, or you pay only the interest, but after a certain number of years you have a higher interest rate and/or balloon payment. So even if you don't have a subprime loan, problems in the subprime market will migrate to the creative financing market, and then to the regular prime mortgage market.
GMJ: How did the situation become a crisis so fast?
Jacobe: Most of these borrowers got subprime loans at high interest rates; it was the only opportunity they had to get a loan. And though some of these loans were clearly predatory, most of them were just expensive.
There will be a lot of debate about the difference, but when times are good, it's not easy for a regulator or a lender to say, "No, this is ill advised, and I'm not going to let you borrow money." Instead, what the lenders would say is, "Well, the value of the houses we're lending money on is increasing, so the real risk of making the loan is not high. If the borrower can't make the payments, they could sell or refinance the house and thus, avoid default." And when times were good, the booming housing market kept the default rate down.
But in the last year or so, housing prices in a lot of runaway markets have come down. Overall price levels and values have lowered. As a result, some of the people who have high-rate loans can't make their payments, and because they don't have any equity, they can't get out of their mortgage by selling the house. They often find they can't refinance for a number of possible reasons, such as the loan they would need to refinance might now exceed the value of the house, the new payments may exceed their ability to pay, their payment difficulties have further impaired their credit, or loan underwriting standards have tightened as loan defaults have increased. So the default rate goes up because of changing economic circumstances in general and declining housing values in particular.
GMJ: But this is predatory lending, isn't it?
Jacobe: Everybody is asking that -- on Capitol Hill and everywhere else. Have lenders been taking advantage of people who don't know better? Were lenders getting borrowers into loans they couldn't pay, then putting them into foreclosure?
On the one hand, you can argue that providing mortgage loans for marginal borrowers is actually a good thing, because it gives these families a chance at homeownership that they might not get otherwise. Increasing homeownership is clearly a good thing.
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On the other hand, making loans to marginal borrowers is usually done at higher interest rates and with the understanding on the lender's part that these borrowers are high risk and may default and lose their home. Of course, knowingly taking advantage of people by lending them money at very high rates with very high fees knowing they will be unable to pay it back can be seen as predatory lending.
In recent years, I think lenders and their regulators have tended to emphasize providing the home borrower with information and the attendant responsibility to decide for themselves whether they can make the loan payments the lender offers them. The idea is that more choices are obviously better than less for the potential borrower.
Personally, I tend to agree with the results of our recent Experian/Gallup Poll, which was completed in May. In that poll, only 16% of consumers told Gallup that they feel the availability of subprime loans is generally a good thing because more consumers can own a home, while 74% said it was a bad thing because borrowers get into loans they cannot afford. (See "Will the Subprime Meltdown Be Contained?" in the "See Also" area on this page.)
I think the mortgage loan process is so complex that many borrowers tend to rely on their lender -- and indirectly on banking regulators -- to help them know how much they can borrow. Even more importantly, I think losing your home to foreclosure is such a terrible experience for the family and the community that lenders and regulators must accept some responsibility to help the consumer avoid predatory lending.
Now, the surge in home mortgage defaults has banking regulators taking more responsibility by forcing lenders to tighten their mortgage underwriting standards. As a result, there will be less mortgage financing available, not only because of the losses subprime lenders took, but also because of new regulatory sanctions.
GMJ: What effect will this have on the general housing market?
Jacobe: Well, it will affect home sales because all those marginal borrowers can't get into the market. So people who want to move up by selling either low-cost new homes or older homes can't sell their homes to these borrowers, because they can't get a loan anymore. When you take a significant percentage of the people who are buying homes out of the market, then home sales will go down. And when you add a significant number of foreclosures to that, you get so-called distress sales, which means that somebody just has to unload the house even if they take a loss. Or a lender takes it over in a bankruptcy filing and just wants to sell it, even at a loss. When that happens, it drives prices down some more. It is a cycle that builds until the market consolidates the excess inventory.
I agree with the 59% of consumers in our May poll who believe that the problems in the subprime market will spill over into the overall mortgage and housing markets, not the 25% who believe these problems will be contained.
GMJ: How long will that take?
Jacobe: Longer than many on Wall Street anticipate. I think what some people may have missed -- because we haven't had a real, significant economic downturn in more than a decade -- is that consumer finance in general has been flooded with liquidity for the last several years, the last four or five years in particular. So loan standards and lending standards that were established and maintained for many years were relaxed as lenders competed for borrowers. There was a lot of credit available, while the interest rates that the lenders paid for the money have been very low. So lenders could fund these loans and get good rates of return. The subprime market in particular was one of the few places you could get a really good rate of return. So the competition became intense, and lending standards declined as a result.
I think that many people associated with the mortgage and housing markets knew that there were excesses in the way loans were being underwritten and in housing prices. But just like any other kind of bubble, when you're looking at the current situation, you say, "My experience says this will burst, but right now I can't prove it, because the default rate's not bad and housing values are going up." So they stayed in and made more loans. And then the bubble burst.
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Now, housing values will go back up, but the balance has to be addressed. Most of the speculators have gotten out of the market, and so, after some period of time, housing prices will rebound. History teaches us that. But there will be a period of consolidation, and prices will need to become more reasonable and less speculative. Unfortunately, this is a long process, usually measured in years, not months.
GMJ: What effect will this have on the economy in general?
Jacobe: There are at least three ways that it can have a general effect. One, the housing market itself has an impact on the economy overall. Many businesses are related to the housing market, such as home improvement, home furnishings, and appliance stores, as well as mortgage bankers and real estate brokers. A lot of those businesses, which have been booming, will suffer as a result of the downturn in the housing market.
Second, another part of the economy was driven by home equity loans. Some people got cheap loans based on the equity in their homes. Other people were using their homes as an ATM machine to support consumer spending -- they could buy things that they might not have before, such as home improvements, cars, and boats -- all kinds of things, because they took the equity out of their home and turned it into cash. People felt better about doing this because if the value of their house was going up, then they didn't worry as much about having more debt, and when interest rates were low, they felt like it was a good deal. But that also put many consumers deeper in debt.
The third thing that's going to happen as a result of the problems with subprime loans is that there can be a general effect on credit. I think that's the one problem that's hard to perceive right now, but I think it will happen. In general, we can expect banking regulators and the lenders they supervise to tighten consumer loan underwriting standards. That means there will be significantly less liquidity available to consumers than in the recent past. When that happens, generally speaking, consumers will tend to pull back [on spending] because they have less money available to them in terms of credit.
GMJ: Do you think all of this will cause the Fed to ease monetary policy? And if so, what will the upshot of that be?
Jacobe: Well, it depends on how much the current housing situation slows the economy. There's a lot of debate about this. My feeling is that the economy will continue to slow, and slow more than people anticipate, as we continue through this year. When I add in higher gas prices, then I think the economy can slow quite a bit more.
So, there will be a general economic effect, and I think it is likely to put us into a recession later this year or early next year. If it looks like we're going into a recession, then the Fed may cut interest rates. To some degree, that [action] depends on what's happening on the inflation front and in the world economy. If the world economy stays strong and the U.S. economy declines, as some people hypothesize it will, it's theoretically possible that the United States could continue to have inflationary pressures that will make the Fed feel uncomfortable about reducing interest rates. My own guess is that although the world economy has changed a great deal in recent years, I don't think it can continue to do well without the United States. And so I think if the U.S. economy goes into a significant slowdown or recession, then the world economy will slow, with some lag, and as a result, I think the Fed will cut interest rates late this year.
I also think we are likely to see a move in Congress to do something for subprime borrowers. In the Experian/Gallup Poll, we asked if the federal government should pass new legislation designed to help subprime borrowers keep their homes and avoid foreclosure; 57% said yes, while 37% said no. I think this legislation will happen because securitization -- the process by which lenders sell mortgage loans to investors -- has made it much more difficult for individual lenders to provide borrowers with any real degree of forbearance.
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It used to be that most mortgage loans were made and held by local lenders. If the borrower got into trouble making their payments, then both the lender and the borrower had the ability and the incentive to find a way to help the borrower with some temporary relief that avoids foreclosure. Now, most mortgage loans are held by investors who have no contact with the borrower and no way to work with the borrower to prevent loan default and foreclosure. The current housing crisis will be the nation's first real experience with today's (securitized) mortgage finance system under distress. Evidently, the outcome of this test worries me a lot more than it does the Fed and the equity markets.
GMJ: Given your far-from-rosy outlook, how do you explain the Dow's continued strength? Are you maybe too worried, while the economy might be a lot stronger than you think?
Jacobe: That is always possible. Right now, however, I think the equity markets are being affected by all kinds of factors related to the world economy, globalization, and an abundance of liquidity worldwide. We see numerous mergers, companies buying back their stock, and other companies being taken private. In other words, I think there is a lot of money out chasing relatively fewer good investments.
I think the real thing that would hurt the equity markets and the economy is a credit crunch. It's theoretically possible that the excessive liquidity that's existed worldwide during the past several years could lead to a regulatory-induced credit crunch that could have all kinds of lenders pulling back. And if that happens, we'll have a problem of a totally different magnitude.
Whether and how you reconcile totally different underwriting perspectives by lenders and a reduced level of world liquidity with the current world economy may be a major issue during the months ahead. That's why many people who are watching the housing market (which I think is going to get a lot worse) think the stock market is a little too optimistic right now. On the other hand, maybe mortgage securitization and globalization have so changed things that the lessons of history no longer apply to the U.S. economy. We'll see.
-- Interviewed by Jennifer Robison