Don't Expect Fed to Accomodate Market's Subprime Woes

The recent implosion of the subprime mortgage sector has contradicted the notion – prevalent earlier in the year - that the worst has passed for the housing sector. Indeed, every sector tied to housing and real estate has been leading the market lower in this correction. Stocks of subprime mortgage lenders have of course been decimated.

About 25 mortgage lenders have announced that they are either stopping their lending activities, going out of business, going into bankruptcy, or looking for somebody to bail them out. Indexes of homebuilding stocks have fallen 15%. REITs have declined 10%. Major Wall Street broker/dealer firms (key players in the securitization of mortgages) have fallen 11%. It is quite possible that the sub-prime debacle will be contained and not spill over into the general economy or lead to a broader credit crunch. That is the view of the Federal Reserve and the consensus view among investors. But no one really knows the size of the mortgage lending problem.

Many of the same non-traditional lending practices that are cited in connection with the subprime meltdown were used in “Alt-A loans” (the next rung higher on the mortgage credit ladder) and even in prime loans. These practices include zero down payments, inflated appraisals, balloon mortgages, and lack of documentation for assets and income. According to the National Association of Realtors, from mid-2005 to mid-2006, 29% of homes were purchased with zero equity. Moreover, no one really knows at this point what effect these mortgage issues will have on the real estate market, which is already suffering from an inventory problem, and on consumer spending, which has relied in recent years to an unprecedented degree on the “wealth effect” from real estate appreciation and home equity extraction.

The recent disappointing report from the Commerce Department on February retail sales suggests that softness in housing and stress in the mortgage markets is causing consumer spending to falter despite a firm labor market. Year-over-year, retail sales have been flat in the first two months of 2007. In short, tightened mortgage credit conditions coupled with an ongoing inventory problem in housing and soft home prices represent a continuing risk to the economy. Furthermore, credit excesses and high leverage are issues that plague the economy and the financial markets as a whole. They should not be taken lightly as they have the potential to create additional shockwaves in the months to come.

The Federal Reserve is closely monitoring the weaknesses in the housing and mortgage markets and is widely expected to quickly change its hawkish tune if credit issues spread outside of sub-prime mortgage lending, or if there is a larger dislocation in the financial markets. The markets have an abiding faith, nurtured in the era of the “Greenspan put” (a reference to the Greenspan Fed’s tendency to lower interest rates in response to financial market dislocations), in the readiness and ability of the Federal Reserve to rescue the investment community from any potential financial crisis.

Accordingly, investors will be intensely focused on the Fed’s actions at this week’s FOMC meeting on March 20-21. Markets no doubt are hoping that the Fed acknowledges heightened risks to the economy and the financial markets and opens the door to interest rates cuts in the months ahead.

Indeed, markets are currently discounting multiple Fed cuts over the balance of 2007, though that view has yet to be validated in the least by the Fed itself. Given that the Fed is caught between housing/mortgage market stress on the one hand and persistent inflation pressures on the other, we are not so sure it will be so accommodating to the financial markets, at least in the immediate future.