Although the direct cost of the subprime crisis will likely be modest in the scope of the economy, the spillover effects are concerning. Shocks to financial markets appear to have begun a reversal in the ease of obtaining credit, a change in investors' perceptions of risk and a continuation of housing market declines.

Therefore, as this situation continues, it is important to ask how the subprime meltdown might affect you. Read on as we examine this question.

Size of the Subprime Market
To get an idea of the total direct impact of the subprime lending crisis, we will take a look at its size and make an estimate of the overall loss. (For background reading on what happened, see The Fuel That Fed The Subprime Meltdown.)

According to a July 2007 report by AMP Capital Investors, the total value of all subprime loans is approximately $1.4 trillion, of which only about one-third of outstanding loans could reasonably be expected to default. Even if a loan defaults, it isn't a total loss as the bank can sell the home.

If we assume that in the event of a default, a home can still be sold off, on average, for two-thirds of its original value, the total losses on subprime loans shouldn't go much higher than $150 billion.

Clearly, subprime losses are only a fraction of overall economic activity. The U.S. economy produced around $13 trillion in gross domestic product (GDP) during 2006, and according to January 2007 data from the World Federation of Exchanges, the total value of all stocks in the world is about $50 trillion. So, what this tells us is that even in a worst-case scenario, the pain in the subprime market alone may not have a major impact on the overall economy.

However, it isn't just about the losses from loan defaults that investors and other market participants are worried about. It is the potential spillover effects of the subprime mess that could have a much greater impact on the overall economy - it even brings up talks of the dreaded possibility of recession.

Impact on Borrowers
A major impact stemming from the subprime meltdown has been the reduction in available funds for borrowers. The group most affected by this reduction is "lower quality" borrowers. Subprime lending has dried up as a result of both the collapse of lenders and the reduction in desire to lend to this group. (To learn more, read Subprime Lending: Helping Hand Or Underhanded?)

With the recent meltdown in subprime markets, investors are now more aware of the credit risk inherent in these types of investments. As such, they will require a higher rate of return to compensate for the additional, perceived risk. This translates into higher interest costs for lower quality borrowers and a higher cost of home ownership.

Additionally, many lenders have suffered severely for making these types of loans. Numerous firms have gone of out business or had their stock prices pummeled by frantic investors. Firms that are already in the business of making low quality loans will likely be much more stringent in their underwriting standards. Moreover, they may also seek to diversify their portfolio of loans to include more high-quality borrowers. (To learn more, read Dissecting The Bear Stearns Hedge Fund Collapse and The Rise And Demise Of New Century Financial.)

Furthermore, firms that are not currently in the business of making low quality loans will be much less likely to enter into this business for fear of financial losses and investor reprisal on their stock price. These factors will almost certainly work together to decrease the supply of loans to low-quality borrowers, thereby diminishing the pace of growth in home ownership and hurting the housing market.

What this means to borrowers - The next time you go to the bank for a loan or a mortgage it will likely be more difficult to get and more costly.

Housing Prices
As lower quality borrowers lose their homes or find it more difficult to purchase them, this also puts downward pressure on real estate prices, all but closing the spigot of home-equity withdrawals. (For more insight, read Home-Equity Loans: The Costs.)

Basically, the reduction of easy credit in the market leads to fewer people being able to get a mortgage to purchase a home. The lower the number of people who are able to purchase a home, the lower the demand for homes. As a result, prices are likely to fall. (For related reading, see Profit As Your Home's Price Changes.)

Not only will the reduction in credit reduce home prices from the demand side, supply is also increasing, as foreclosures hit all-time highs. In the event of a mortgage foreclosure, the collateralized property is given back to the bank, which is forced to sell it if it wants to recoup its money. As these properties are put on the market, supply increases, which leads to pricing pressure in the market. (For more on this, see Economics Basics: Demand and Supply.)

These factors only have the potential to weaken the already reeling housing market, which can hurt those looking to sell and especially those who are looking for home equity loans.

What this means to homeowners - It could be next to impossible to sell your home for a premium, and don\'t look to your home equity for your next big purchase.

Real Estate/MEWs/Consumer Spending
The fallout from the subprime meltdown could impact economic growth through the housing market. This is because real estate makes up a large portion of overall economic activity and home equity withdrawals have buoyed consumer spending over recent years.

Figure 1 illustrates the direct relationship between growth in housing prices (red line) and equity withdrawals (blue line) over recent periods.

Figure 1
Note: The data presented herein are believed to be reliable but have not been independently verified. Any such information may be incomplete or condensed.

The fear that many have about the reduction in housing prices is that it will hurt consumer spending. For many years, during the real estate boom (2001-2005), homeowners who saw their properties shoot up in value used mortgage equity withdrawals, which allowed them to unlock value from their homes through a home equity loan.

Homeowners could use these funds for investment or to make purchases, which helped to fuel economic growth through consumer spending during the housing boom. In a 2007 study by Alan Greenspan and James Kennedy, it was estimated that U.S. consumer spending was increased by nearly 3% due to home equity extractions. (For related reading, see Using Consumer Spending As A Market Indicator.)

As housing prices and equity withdrawals tumble, the fear is that consumer spending, which is a large portion of economic growth, will be severely impacted. If this occurs, we are likely to see economic growth slow or even fall, creating fears of possible recession and hurting the U.S. and global financial markets.

What this means to the economy - There is an increased risk of a downturn or even a recession in the economy as consumer spending is put under pressure and the housing market slows.

Credit Markets: Risk Shift
Although the effects of the subprime market meltdown on interest rates and accessibility to home ownership are significant for borrowers and the housing market, there has also been an impact on the way investors are looking at the market, specifically the credit markets.

It appears that subprime crisis, and the resulting well-popularized business and investment failures, are causing a broad panic in credit markets.

To illustrate, take a look at the chart below that displays the option adjusted spread (OAS) between Treasury and high-yield bonds. Essentially, this chart indicates how much compensation investors require for taking credit risk. A sharp increase in this premium is obvious from the first rumblings that were heard in the subprime markets in early 2007.

Figure 2
Note: The data presented herein are believed to be reliable but have not been independently verified. Any such information may be incomplete or condensed.

Even though the panic in credit markets was swiftly assuaged by the world's central banks through several hundred billion dollars in liquidity, it is arguable that recent events have lead investors to re-examine credit risk in general. (To learn more, read How do central banks inject money into the economy?)

In turn, investors are now requiring higher rates of return for credit risk, which will slow the economy as the cost of capital broadly increases for corporations and individuals. In the event of increases in capital costs, companies are less attracted to borrowing money to fund expansion, which hurts economic growth.

Also, with less credit available in the market, we are seeing a decline in the number of leveraged buyouts in the stock market. For the past few years, the stock market has seen a huge number of billion-dollar deals that saw hedge funds and other large investors take large companies private. These funds would borrow billions of dollars, backed by the firm's (borrower's) assets to take the acquisition private. This helped to boost stock prices higher and created a buyout premium in the market. With less access to credit, the premium has been reduced along with the likelihood of buyouts in general.

In all fairness, such occurrences are common after prolonged periods of excess liquidity such as the one we have been experiencing since 2001. Therefore, the subprime crisis should be perceived as a psychological catalyst for a long overdue correction in credit markets, but not necessarily the underlying problem.

What this means to companies - With the reduction in liquidity and increased risk premiums it will be more difficult and expensive for companies to borrow money and fund operations. This could hurt economic growth.

What is really interesting about the subprime situation is that even though it has had a minimal direct loss to the economy, the ensuing effects are undeniable. It is amazing to see a mere $100 billion in losses (or 1% of annual GDP) lead to the failure of multiple lenders and investment firms, while also serving as a catalyst to a broad correction in credit markets and investor perceptions across the broad.

What the average person can take away from these events is that history regularly repeats itself in the world of investing. Periods of economic excess are inevitably corrected in precipitous and unpleasant ways. Keep in mind that for prospective returns to increase to compensate investors for higher risk, current prices must drop. As such, investors should be wary of loading up on risky investments in this type of environment.

(For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subprime Mortgages Feature.)

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