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Mortgaging Health of the Economy?

October 18, 2007 By:
Joel L. Naroff, JE Feature
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Subprime, subprime, subprime. That is all we seem to hear these days.

The stock market bounces violently every time a mortgage lender or hedge fund gets hit by subprime mortgage problems. The Fed is forced to express awareness that credit standards have been tightened because of the subprime concerns. All the while, the economy continues to grow somewhat sluggishly.

So, will the subprime market become the monster that devours the economy? Probably not, but it will not go away without leaving its mark.

What is subprime? As explained by the Department of Housing and Urban Development, typically, subprime loans are for persons with blemished or limited credit histories. The loans carry a higher rate of interest than prime loans to compensate for increased credit risk.

As the housing bubble built, some lenders expanded the use of subprime mortgages to put people into homes that were otherwise unaffordable. These were often variable rate mortgages, and when the rates reset, people saw their monthly payments jump. Not surprisingly, it turned out that many people who couldn't afford prime loans also couldn't afford the subprime loans.

Now, there is fear that lenders -- facing losses -- will reduce their lending, creating a credit crunch. Credit standards were eased dramatically during the housing boom. Now that lenders are moving back toward more realistic standards, it seems as if credit has been reduced. But that is only because there was just too much credit issued.

More Slowing Possible
The impact on the economy, however, could be real. Growth looks to be throttling back from the solid 3.4 percent second quarter pace; consumer spending has moderated. If credit is reduced to households and businesses that have good credit, a further slowing could result.

Can the economy absorb the problems being created by the subprime lending losses? Probably yes. As long as jobs are added to the national profile, households will have money to spend.

They may not shop till they drop, but they likely will visit the malls. Also, world growth remains strong, and companies that do business globally are doing well.

The economy may expand modestly the rest of the year, but unless there is a major credit crunch, a serious downturn should be avoided.

Yet while the focus of attention remains largely on the subprime problems and the faltering housing sector, it has begun to shift back to the consumer. The extensive use of imaginative mortgage products to put people into homes who couldn't afford those homes was a major driving force in the economy.

But the economy still seems to be growing, even if it is only sluggishly. To sustain the expansion, consumers will have to keep emptying their wallets, and it's not clear yet to what extent that will happen.

With the credit crunch having hit in August, worries abounded that the economy could tumble. Those concerns were magnified by the August employment report, which initially indicated that firms cut payrolls.

The first job decline in four years was a shock and ultimately led to the Federal Reserve reducing the funds rate by 50 basis points in mid-September.

But then we discovered that the Bureau of Labor Statistics had some trouble counting. The August payroll decline of 4,000 turned into an 89,000 increase. July's soft job data was revised upward as well. The private sector is still adding workers. However, the gains may be enough to keep the economy going, but they clearly do not indicate that firms are hiring like crazy.

So, what state is the economy in? The data do seem to point to us skirting a recession. Job and income growth are decent enough to generate at least mediocre spending. But we have yet to see the price increases that will ultimately come from the $80-a-barrel oil.

In addition, the housing market continues to spiral downward, and falling home prices will likely further slow spending. This is a process, not an event.

There isn't just one month of problems. Instead, we will continue to see a flow of defaults over the months to come, and that likely will cause home prices to fall further. Weak housing conditions rarely cause consumers to go out and spend.

Upcoming Holiday Spending
At this time of year, gauging household spending means forecasting the holiday shopping season. Many analysts are worried that it could be less than hoped for, especially if job gains don't hold up.

Department stores seem to share that concern. We already are seeing early season discounts as retailers try to sell as much as they can, as soon as they can. That aggressive marketing approach could be a boon for households and might save the season.

As the consumer goes, so goes the economy, and any half-decent holiday spending should keep the expansion on track. But strong growth just doesn't look to be in the cards, and that worries the Fed. The monetary authorities have indicated they are ready to move as needed. What could get us another cut in interest rates are signs that consumer demand is fading.

Additional rate cuts would be welcomed. It would lower short-term interest rates, and that would make consumer loan products cheaper.

Joel L. Naroff, Ph.D., is chief economist for Commerce Bank.

 

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