NEW YORK (Reuters) - The audacious rise in the Dow industrials to a record will do little to prevent the millions of new “For Sale” signs likely to dot U.S. lawns soon.
Fears of mounting foreclosures and predictions of a lackluster holiday season remain even in the face of Dow 14,000, which has removed some, but not all, uncertainty about the faltering U.S. housing market.
At the root of investors’ anxiety are so-called subprime loans made to borrowers with shaky credit. Delinquencies are rising on subprime mortgages and defaults are piling up at record rates as home prices sink, pressuring consumers’ desire to spend.
The ripple effect from the slump in housing doesn’t stop there. Strains still exist in the U.S. credit markets even though there are signs of easing in the global liquidity squeeze, which was triggered by a lack of confidence in financial markets as subprime mortgage defaults soared.
Already, the housing slowdown has subtracted about 1 percentage point from growth in inflation-adjusted gross domestic product so far this year.
“I don’t think the worst is over,” said Robert Arnott, chairman of Research Affiliates LLC, a Pasadena, California-based investment management firm.
“We are coming off the greatest lending bubble — not housing bubble! — in U.S. history. We will feel its impact for a very long time.” For more investor comments see <ID:nN02411723>
Falling home prices are leaving subprime borrowers who took out adjustable-rate mortgages with a major dilemma. Millions with subprime mortgages, which go to borrowers with checkered credit histories, are faced with negative equity in their homes that could make it increasingly unlikely they will qualify for new mortgages in an environment of tighter lending standards.
At current home prices, about $693 billion in ARMs are “already under water,” according to Stephanie Pomboy, financial economist at MacroMavens in New York.
TWIST OF THE ARMs
That’s frightening news for banks that already have absorbed losses on their balance sheets due to delinquent subprime borrowers. The losses so far amount to about 10 percent of the forecast of $100 billion in losses.
“The disturbing number here isn’t 10 percent ... but the $100 billion,” Pomboy said.
With nearly $700 billion in ARMs in negative equity facing interest-rate resets, “depending on how much lenders can ultimately recover, this implies (bank) losses will be more like $210 billion to $346 billion,” she said.
“And that’s assuming the situation doesn’t get worse.”
In July, Federal Reserve Chairman Ben Bernanke had estimated the losses at $100 billion at the most.
But it appears Bernanke had underestimated those figures and their effects on the consumer.
In September, the Fed took the benchmark federal funds rate, which governs overnight loans between banks, down an aggressive half-percentage point to 4.75 percent, its lowest since May of last year. The Fed also cut the discount rate it charges for direct loans to banks by a half-percentage point to 5.25 percent.
“With the reset wave about to gather intensity and ‘For Sale’ signs dotting the lawns of 5.1 million homes across the country, the credit hit parade has only just begun,” Pomboy added.
Aside from the resetting of interest rates on home mortgages and falling home prices, both leading to a slowdown in consumer spending, Arnott of Research Affiliates is concerned about slumping home construction.
That, he said, was 5-plus percent of Gross Domestic Product at the latest housing peak. He puts the odds of recession around 60 percent.
Indeed, September was a record month for investment-grade issuance of about $100 billion, but that came as conditions in the commercial paper market remained tight.
Since August, U.S. commercial paper outstanding shrank by $370 billion, with commercial and industrial loans also helping to pick up some of the slack. Now, those loans are growing at the fastest rate in more than 20 years, Goldman Sachs’ chief U.S. economist Jan Hatzius wrote in a research report published late on Monday.
All told, the stock market is underpinned by powerful factors. U.S. equities appear cheap relative to many asset classes, especially since Wall Street has been a laggard in the global equity rally over the last several years. And now that many oil-exporting countries are flush with cash, they’ve been putting that surplus money to work in higher-yield securities in the United States.
“Investors with new money to put into the marketplace probably will be less interested in certain other real asset classes, like houses, because the luster has come off the sector,” said Keith Wirtz, president and chief investment officer at Fifth Third Asset Management in Cincinnati.
Ironically, equity markets have created the least amount of “grief” for investors in this cycle, he added.