Subprime: Reality Check

You hear about it all the time lately - subprime! It's everywhere, kind of like your American Express card, maybe not where you want to be though.

No one wants to be in the middle of the subprime debacle right now, but unfortunately, there's virtually nowhere to hide for any of us. One way or another, subprime could hit us all. The billion dollar question is whether it's really that bad, or whether the whole situation is more a just a case of Chicken Little type of hype. (To learn the basics of the subprime debate, see Subprime Lending: Helping Hand Or UnderHanded?)

Where We Are Now
By no means can we just call the subprime mess hype. In fact, much of the recent rate cut by the FOMC can be attributed to subprime issues. Businesses are leery of commercial paper investments, lenders are tightening their borrowing requirements and consumers are getting spooked.

Case in point, during the week of August 22, consumer confidence took the largest weekly dive since Hurricane Katrina, according to the ABC News/Washington Post consumer comfort index. What's more, the personal finance portion of the index is at a three-year low. The recent declines in U.S. and global markets have caught the eyes of consumers, who are now more tepid than ever. However, the respected organization Economy.com asserts, "we do not believe that the recent turmoil in global financial markets is severe enough to alter our consumer outlook, which calls for real spending growth to hover around 2% annualized in the third and fourth quarters."

But here's where we could quickly see things go from Ok to bad. Right now, mortgage underwriters don't really need to tighten lending standards, but many simply are anyway. There are plenty of loans still being doled out to mediocre credit consumers. Lenders want business, and the mortgage environment is certainly competitive. Thus, even with all of the subprime woes, many interest-only and ARM loans are still being granted to run-of-the-mill credit consumers. (To learn more, see ARMed And Dangerous.)

Even though this would seem like a good scenario for all (given that more mortgages help support and drive up real estate prices), reckless lending coupled with exuberant spending on the part of credit card happy consumers, could easily create an inflationary environment. Adding one more wrench in the works is the fact that crude is still trading around $70 per barrel, and on an inflation-adjusted basis, could soon hit $100. All of these factors combined could tie the Fed's hands when it comes to future rate cut decisions. At this point, a rate hike would only further exacerbate the subprime problem; thus, I suspect we'll likely see another discount rate cut in September.

Overall, considering subprime loans top $1.2 trillion (according to Economy.com), up from almost nothing one decade ago, the subprime risk is certainly more than just Chicken Little hype. However, it may not be "totally devastating".

Life Goes On
Looking back into history, we can find some similarities between today's subprime mess and the savings & loan scandal of the 1980s. During the 80s the total losses were in the $150 billion area, though about $125 billion was shouldered by the United States. And it's important to mention that from 1980 to 1990 the Dow Jones Industrial Average climbed 200%, even with the S&L debacle and the crash of 1987.

One potential difference now, however, is that subprime loans are almost eight times what the losses from the 80s were. It's hard to imagine the United States could shoulder the entire subprime burden, considering it could equate to more than 10% of 2007 GDP. But the Feds are trying to help, as noted in the recent half point cut in the discount rate. What's more, to date, the Fed has injected over $80 billion into the economy, also helping to ease subprime woes.

With all of the aforementioned in mind, it's probably not likely that a worst-case scenario will unfold, especially since GDP growth remains healthy at 3.9%. (To find out how bad things could get, check out Subprime: Nightmare Scenario.)

Moreover, with over two dozen major lenders having already filed for bankruptcy, at least the "sticker shock" of the whole thing has already set in. Now it's just time for corporate America to roll up its sleeves and keep earning.


Bottom Line
We're not totally out of the woods yet. Third and fourth quarter earnings reports could hang a dark cloud over Wall Street, as charges for defaulted commercial paper investments start showing up. But one thing is for sure, corporate executives have been aware of the situation for awhile, and are most likely working hard to compensate for any subprime-related losses. After all, they are in business to make money, not lose it.

Overall, yes, subprime is bad, and U.S. stock markets may still see a significant pullback in the third, or fourth quarter. However, life will go on... and so will the markets.

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


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