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ECONOMIC ANALYSIS: Why subprime 'crisis' is not as severe as it seems

January 28, 2008

Over the next few years, quite a few doctoral dissertations are going to be written about the subprime loan market, and its effects on the overall U.S. economy. And whatever the effects turn out to be, it is certain that this financial mess has all the twists and turns of a spy novel. Here is part of the plot:

Over the past decade and half, home prices skyrocketed. The causes included rapid growth in the U.S. economy, aging baby-boomer purchases of vacation homes and, most important, low mortgage rates. In many places, these rapid price increases made buying a home difficult for the average family. But financial institutions, struggling with low interest rates, offered a new set of financial instruments and pushed some older ones. We now call these subprime loans.

In the 1980s, Congress created Freddie Mac and Fannie Mae, the financial market giants, primarily to construct a market for mortgage-backed securities. Congress did this to extend the opportunities for mortgage loans. The effort worked well, and mortgage loan availability extended nationally.

After 9/11, the U.S. government deficit rose, while consumers continued to spend and interest rates remained low. This placed downward pressure on the dollar, and exchange rates dropped. Since oil is denominated in dollars, our energy prices rose.

That's the background. Here's the spiral of events:

In 2005, modest evidence of inflation and a robust economy led the Federal Reserve to raise rates. This led to increases in adjustable-rate mortgages, with some inevitable foreclosures. Here's the kicker, though: No one really knows how extensive foreclosures may become. We do know that 20 years ago only about $200 million worth of mortgages were floating around secondary markets. Today, it is $2.2 trillion. Most of these loans are not subprime, and even most of the subprime borrowers are in no danger of foreclosure.

To place the magnitude of mortgage securities and at-risk loans in context, we would do well to remember our economy is $13 trillion annually, with nearly $50 trillion in loans of one sort or the other. In that context, $200 million is a rounding error. So even if a quarter of the traded mortgages are bad-some $500 million or so-there is no crisis.

Again, the real worry is that we don't know how many mortgages will default, and this uncertainty causes the share price of financial institutions to drop. The problem arises from this devaluation of assets (and inability to borrow further). After all, banks must have financial resources in order to make loans. Without loans, the economy does not work.

Still, this may well turn out to be the ebb and flow of business. Perhaps most telling, mortgage rates have declined, sure evidence that no credit crunch has yet emerged. Most important, policymakers haven't even begun to employ the tools of monetary and fiscal policy that are available. Whatever does happen, the next few months will be a real thriller.



Hicks is director of the Bureau of Business Research at Ball State University. His column appears weekly. He can be reached at bbr@bsu.edu.
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