Mortgage pain won’t derail the economy

IF you want to be afraid, really afraid, think of the High Grade Structured Leveraged Credit Strategies Enhanced Leverage Fund. This hedge fund, run by Bear Stearns, is struggling to raise cash so it can avoid collapsing.

Its assets consist in good part of bonds backed by sub-prime mortgages, loans made to borrowers who are less-than-good risks. Rising default and late-payment rates have called the value of these mortgages into question, prompting the banks that lent the fund $6 billion to demand repayment. Since the fund has only $600m in investors’ capital, Bear Stearns has no way of repaying creditors, and is scrambling to obtain new loans and new equity capital. In short, the fund finds itself in a position not very different from that of sub-prime borrowers, only on a huge scale.

This might be a matter of no concern to policymakers: bad luck for well-informed and well-heeled investors and lenders such as Barclays, Merrill Lynch and Citigroup that underestimated the risk involved in investing in this fund. But there might be collateral damage. If the assets that underlie the fund, now being auctioned off, bring only knockdown prices, similar assets now valued in trillions of dollars might also be revalued sharply downwards. That would hit the earnings of several big banks, reducing their willingness and ability to lend, possibly contributing to the slowing effect on the economy of falling home sales.

But before being very afraid, know two things. The financial markets have so far reacted with an indifferent shrug. And the people on top of this situation do not see any such systemic risk in the economy’s future. I base that on talks with key government officials who are paid to watch these things. A composite of that information looks something like this.

The problem of defaults and repossessions is not a trivial one, but nor is it likely to bring down the economy. The mortgage-market turmoil has several causes. The recent rise in interest rates caused monthly payments on variable-rate mortgages to rise to levels that many sub-prime borrowers cannot meet. Most of the problems are concentrated in the “rust belt” states, where workers in industries suffering from a combination of mismanagement, rapacious trade unions and imports are finding it difficult to keep up their mortgage payments. Since any candidate who hopes to capture the White House must carry these states, attention must be paid. Also, a disproportionate number of the troubled borrowers are black, adding to the political heat. Most important, key policymakers believe in the social value of widespread home ownership, and are eager to keep credit markets open to sub-prime borrowers, many of whom are good credit risks.

Still, there is a feeling in some political circles that if a borrower takes on debt he cannot repay, and his house is forfeit, that is his problem – not society’s. And if lenders are foolish enough not to enquire into the borrowers’ ability to pay for their loans, they deserve the losses they will inevitably face.

Unfortunately, life is not so simple. Since defaults and repossessions are concentrated in a few areas, the sprouting of for-sale signs on the repossessed properties drives down the value of the houses owned by families able to meet their mortgage obligations. In addition, families in arrears often reduce spending on maintenance, creating eyesores that damage a neighbourhood’s appearance and drive down the value of properties owned by solvent homeowners.

This can breed social problems such as higher crime, truancy and neighbourhood slovenliness. Which is why Freddie Mac chief executive Richard Syron told Congress that his organisation, which benefits from an inferred government guarantee of its securities, feels it part of its reciprocal obligation to “develop more consumer-friendly sub-prime products that will provide stable financing alternatives”.

Equally important, the market is working its wonders. Banks are tightening lending standards; investors have been reminded that if a deal seems too good to be true,there is something wrong with it; and rating agencies, awakened to the risks of bonds that are backed by sub-prime mortgages, have downgraded hundreds of such securities. The emptors will now have more serious caveats laid before them.

Meanwhile, any collateral damage that might be inflicted on the economy has not yet reared its ugly head in the “real economy”. Indeed, despite the turmoil in the sub-prime market, continued woes in the housing sector, high petrol prices, and higher interest rates, the economy is growing at a 3% annual rate this quarter. Retail sales are up, the manufacturing sector is recovering, exports are rising, earnings remain more than satisfactory and – perhaps most important of all – jobs remain plentiful. So be alert, but not afraid.

Put this all together and you have . . . a muddle. If the pessimists are right, the housing sector and the associated sub-prime mortgage market will continue to deteriorate, bringing economic growth to 2% or less, which will push up unemployment and force the Federal Reserve Board’s monetary committee to lower interest rates. If the optimists are right, collateral damage from the housing and mortgage sectors will be a ripple but not a wave, and the Fed will have to raise rates to prevent inflation-inducing growth of closer to 4%. Split the difference – 3% growth this year – and you are probably right, which means the Fed’s monetary committee can take a vacation at least for the summer – or at least stand pat when it meets this week.