Taking Credit's Temperature
Risky home loans run a fever, and the market prays it doesn't spread
Indeed, Cagan estimates that about 16 percent of those hapless homeownersabout 140,000will default annually, and even more if home prices drop by much more than the 1.4 percent decline now predicted by the National Association of Realtors for 2007. The result "will be very ugly," says Cagan. "It won't break the economy. But like Warren Buffett says, 'When the tide goes out, you find out who's been swimming naked. 'And my guess is that it's a lot more people than you might think."
Others warn that even those with their financial swimsuits firmly in place could be exposed if the subprime debacle leads to a wider credit crunch. "The worst case is that all these events cause so much fear that credit begins to flow less freely across the entire market," says Mark Zandi, chief economist at Moody's Economy.com.
Tight. To be sure, demand for subprime-backed securities has all but disintegrated, cutting off financing for many would-be homeowners. Meanwhile, the default scare has also led to tightening credit standards for prime mortgages and is increasingly hampering corporate borrowing, such as the withdrawal of a $600 million bond offering from meat processor Swift & Co. The cause: lack of interest.
But there is also good reason to think that the financial contagion will ultimately be more chickenpox than smallpox. The economy, rather than weakening as it was in February, seems to be strengthening today. After a soft patch, many economists think the economy grew at 3 percent or better in the second quarter. And unemployment is still at a relatively low 4.5 percent.
"For those who thought the weaker economy of last February would surely be tipped into recession by the subprime crisis," argues Donald Luskin, chief investment officer at Trend Macrolytics, "the present reacceleration of growth is a sharp rebuke to their 'housing contagion' theory."
And who knows, the woes in the subprime market may actually have a positive side effect. Many investors who thought subprime debt was a good deal may now seek a safer return in U.S. treasury bonds, pushing U.S. interest rates lower. So in the end, perhaps what doesn't kill the economy will only make it stronger.
With Paul J. Lim and Marianne Lavelle