Finance Highlights 2007 0501 v2 - Laserfiche WebLink

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.' ~ .. SUBPRIME MORTGAGES, HOUSING, AND THE BROADER ECONOMY The subprime mortgage market has been experiencing difficulties recently, and some investors fear that this will result in broader economic weakness. With that in mind, wewanted to look at what the impact of the subprime market mightbeon USeconomicgrowth. The subprime mortgage market is part of the broader housing sector of the economy. In aggregate, housing makes up approximately 5% of the US economy, as measu red by Gross Domestic Product (GDP). When related expenditures such as home refurbishments and furniture are taken into account, housing constitutes approximately 15% of the economy. While not an insignificant amount by any measure, housing is not the most significant component of economic growth. The largest determinant of economic growth is consumer spending, which constitutes roughly 70% of GDP. It is a truism that" as goes the consumer, so goes the economy." So the question becomes: will the subprime mortgage trouble lead to further weakness in the broader housing market and if so, will housing sector weakness lead to reduced consumer spending, and ultimately a weaker economy? The SubDrime Story Subprime mortgages are issued to households with below average credit or income histories and are generally considered more risky than traditional "prime" mortgages. Although they constitute a minorityofthe overall mortgage market, they have become increasingly important in recent years. The proportion of subprime to prime mortgages varies widely by region, with some areas of the industrial midwest having as much as 50% of all mortgages subprime, while other areas have very few subprime mortgages. Recently, many subprime lenders have been forced to declare bankruptcy, and others have tightened lending standards significantly. Observers wonder if this means that buyers with marginal credit will have greater difficulty in purchasing a home. If so, demand and prices in some markets might fall. Furthermore, there is a possibility that credit standards will be tightened not only in the subprime mortgage market, but also in the traditional mortgage market. This could be problematic, particularly since activity in the housing sector has already come off its highs. The Housing Story Most readers are probably aware that the housing market has been slowing for the past year or so. Home prices have declined in some areas, and new construction and sales of existing homes have declined. It is important to note that these declines have come from near record levels; housing activity remains well within the long term historical range. Concern over housing comes in two forms. The first is that economic activity related to home building and construction will decline further, directly impacting economic growth. The second concern is less direct, but could potentially have a bigger impact on the economy. Economic growth in the past several years was driven in part by consumer spending that was fueled by rising home prices. These rising prices allowed owners to extract wealth from their homes via second mortgages or home equity loans. This additional "income" was often spent on discretionary purchases. Rising home prices also contributed to a "wealth effect" similar to that experienced during the late 1990s stock market boom. This "wealth effect" results in consumers that have greater confidence in their overall financial position, which causes them to increase their discretionary spending. If a weaker. housing market causes consumers to reassess their spending plans, economic growth will slow. The ConsumerSpendlng Story Consumerspending represents roughly 70% of GDP. AS such, any slowdown in consumer spending is likely to negatively impact the economy, particularly since the past three quarters have already witnessed below trend growth. While developments in the job market tend to be the biggest determinant of consumer spending, if housing sector weakness leads to even a slight decline in consumer spending, an economicslowdown could follow. Thatisbecause consumer spending tends to be a self-fulfilling prophecy. If consumers hear news reports of a weak economy, or believe that the economy is weakening, they are likely to reign in their spending and cut back unnecessary expenses. This leads to a cycle of bad news, reduced spending, and economic weakness. Whefe Do We Go From Here? Economists and market participants disagree over whether subprime mortgage troubles or housing sector weakness will lead to a broader economic slowdown. At this point it seems likely that if consumer spending remains unaffected by developments in the housing sector the effect on the economy will be relatively small. On the other hand, if consumers curtail or delay spending due to concerns over falling home prices or the reversal of the wealth effect, broader economic growth could be seriously impacted. How this situation is resolved will be one of the most significant factors in determining whether the FOMC institutes further rate increases, remains on hold, or loosens monetary policy. FOMe policy will in turn prove vital in determining the path of interest rates and the bond market. -Brian Perry, Research Analyst Page 2 02007. Chandler Asset Management, Inc, A Registered Investment Advise<