Is the credit crisis over? Not so fast

NEW YORK: 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 US lawns soon.

Fears of mounting foreclosures and predictions of a lacklustre holiday season remain even in the face of Dow 14,000, which has removed some, but not all, uncertainty about the faltering US 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 US 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 sub-prime 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 US history. We will feel its impact for a very long time.”

Falling home prices are leaving sub-prime borrowers who took out adjustable-rate mortgages with a major dilemma. Millions with sub-prime 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.

That’s frightening news for banks that already have absorbed losses on their balance sheets due to delinquent sub-prime borrowers. The losses so far amount to about 10% of the forecast of $100 billion in losses. “The disturbing number here isn’t 10% ... 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%, its lowest since May last year. The Fed also cut the discount rate it charges for direct loans to banks by a half-percentage point to 5.25%.

“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.