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In the U.S. the "Wealth Effect" May Be Gone But Not Forgotten By Stephen Esbin
Whether you choose to call it a mortgage meltdown or subprime crisis the result is the same—it is messy, impacts almost everyone, and is still unfolding. And it’s happening on both sides of the pond. Recent events at Northern Rock, prompted a visiting professor of economics at the London Business School to observe that people were spending more than they could afford because of the increase in home values. In the U.S. it’s called the “wealth effect.” In fact, this has been going on in the U.S for a long time. Everyone’s been talking about it for so long that it’s been like waiting for a train wreck to happen. In the U.S., lower-income borrowers depend on subprime lenders who specialize in higher-cost loans to people with blemished credit records. The demographics of low-income borrowers tend to be women and minorities. Over the past several years the subprime mortgage industry has expanded faster than the prime mortgage sector while homeownership rates for minorities have risen. The argument is that subprime lenders have filled a legitimate marketplace need. While this is true, some argue that subprime mortgages are really about “predatory lending”—supplying unaffordable loans borrowers have no realistic way to repay. The bet was that as home values increased subprime borrowers could refinance. Ah yes, refinancing is the golden key. And why not? Americans have been doing this for years thanks to the housing boom. The new reality is that home values decreased and those facing a “reset” on their mortgage interest rates discovered the expected equity increase was not there. Now, many subprime borrowers are faced with monthly increases of $300 or more. Even when times are good, that’s a lot of money. Subprime loans offer two things to American consumers: first it enables them to achieve the American dream of homeownership and, second, they can borrow against the expected increased value of their homes to pay off other borrowings and refinance before their subprime loan resets with significantly higher monthly payments. There’s a lesson here—if it’s too good to be true then it isn’t. The implications, real or anticipated, are many—a weaker housing market, declining home prices, a threat to consumer spending, and increased rates of defaults and foreclosures. According to some analysts, home prices may fall 5% - 10%. This impacts what is known as the wealth effect — consumers have a false sense of security based on the value of their homes. As home values fall, consumers are no longer able to refinance as easily as they could before. It is widely accepted that the refinancing activity of the past several years fueled American’s non-stop purchasing which in turn supported economic growth. Remember that consumer spending accounts for two thirds of the American economy. Given the current situation, a sigh of relief was heard when Federal Reserve Chairman Ben Bernake took steps to provide liquidity to the markets and then cut interest rates a few weeks ago. However the damage has already been done and it was years in the making. What can be done to assist subprime borrowers now is uncertain. One thing that is certain is that qualifying for credit is much more difficult. The American consumer, and business, now faces a very challenging economic climate. The economic impacts are widespread. New housing starts are declining, construction jobs are shrinking, home furnishings and home improvement sales are slowing, lending rules have tightened, credit card companies are more vigilant, there are signs that the job market is slowing, and retailers are wondering about the Christmas shopping season about to get underway. How this ends may take years. What happens now is most important. Americans have always been able to adjust. As this situation works its way through the economy, it appears that economic growth will slow as consumer credit tightens and they are forced to reduce spending because they are stretched by higher mortgage payments. Some lenders are already renegotiating loans, which provide a ray of hope for those caught up in the subprime abyss. It is certainly not the end of the world, as we know it. But the lessons learned will determine how stable our future economic condition will be. And the “wealth effect” will be placed in its proper perspective until next time. |