• In recent years, residential mortgage loans to folks who couldn't really afford them increased demand for housing, causing home values to rise and encouraging homeowners to fuel the U.S. economy with increased spending.
• Meanwhile, just as rock-bottom interest rates began encouraging lenders to make riskier loans, the Federal Reserve began raising the cost of borrowing with 17 quarter-point increases to the fed-funds rate over the past couple of years.
• Higher defaults among "sub-prime" borrowers resulted when their monthly payments skyrocketed after initial "teaser" interest rates were re-set to current mortgage rates.
• The defaults are leading to stricter lending standards for all types of mortgages, constricting housing demand and threatening to let the air out of inflated home values.
• Lower home values, in turn, may reduce consumer spending, decrease corporate profits as well as business spending and investment, and lead, ultimately, to an economic recession and stock-market declines.

But what are the odds of that actually coming to pass? It’s difficult to say, since there are many large, unanswered questions. Here are a few:

What Is A Sub-Prime Mortgage?
Apparently there is no standard definition. At most, we know that sub-prime borrowers are deemed by mortgage lenders to be riskier than other borrowers, perhaps because they have a low credit score, low income, or have chosen, for whatever reason, not to document their income.

How Much Risk Do Sub-Primes Pose To The Larger Mortgage Market?
As recent market volatility suggests, opinions diverge greatly on this question. Analysts who focus on the direct impact of sub-prime defaults contend the damage will be relatively contained. Analysts who focus on the indirect impact of these defaults argue that problems in the housing sector will spill over into the broader economy. Each side appears to have some merit.

Without a good definition of “sub-prime,” the direct costs of sub-prime mortgage defaults are difficult to pinpoint, but we can make a couple of good assumptions:

• Sub-prime mortgages make up about 15% of the $8 trillion mortgage market - the figure most often cited. (Prime mortgages make up 70% of the market - in other words, the vast majority - and mortgages neither too hot nor too cold fall somewhere in between.)
• As much as 20% of the sub-prime mortgages will ultimately default. (It's closer to about 14% as I write this.)

Under this scenario, sub-prime defaults would represent only about 3% of the entire mortgage market, posing little threat. Moreover, those defaults would not be complete losses for the banks, since when a lender forecloses on a mortgage, it typically auctions the house and recoups two-thirds of the mortgage value. Yes, some of the shakier sub-prime mortgage lenders will go bankrupt, but in general the direct costs will be nil.

By contrast, tighter lending standards induced by sub-prime defaults – both voluntary standards imposed by lenders to protect their loans, and government-imposed standards to protect political careers – could have an indirect cost exponentially greater than any out-of-pocket loss to the lenders themselves. Consequences include loss of investment-banking business built on mortgage-backed securities, and institutional portfolio losses among hedge funds, insurers, and mutual funds who bought the riskier sub-prime loans because they paid higher rates of return.

But by far and away the biggest indirect cost of sub-prime defaults could be decreased home values and decreased consumer spending caused by tighter lending standards. Under this scenario, fewer mortgages will mean less demand for housing, even for homes up the food chain, since entry-level buyers are needed before existing owners can trade up. Less housing demand means falling home prices, which will reduce consumer spending. But the magnitude of this indirect cost depends on the next question:

How Might Lower Home Prices Affect Consumer Spending?
No one knows, since there is apparently no firm understanding of the causal connection between home values and consumer spending. We know that home-equity loans and mortgage refinancings gave homeowners real cash for cars, appliances, and vacations. We also know that increased home equity has a “wealth effect,” encouraging homeowners to spend more in general. We just can’t say by how much.

For example, in 2005, Federal Reserve Board Chairman Alan Greenspan and economist James Kennedy set out to estimate the effect of liquidity from cash-out refinancing, home equity loans, and home sales on overall consumption. Many reams of data later, they determined that borrowing against home equity accounted for 6.9% of all personal disposable income in 2004, or $600 billion. But they did not attempt to answer the $600 billion question: how much of that money actually flowed through to consumer spending?

Will There Be A Recession?
Sure, eventually. That’s part of the normal business cycle. But whether it will happen this year, the next, or, say, after the 2008 Beijing Olympics is, at best, uncertain. To put it in more scientific terms, a recent Wall Street Journal survey of 60 economists found that just under half of them “said they expect the economy to get better over the next 12 months, while 27% expect it to get worse and 22% think it will stay the same.” “Sub-prime Mortgage Woes Are Likely to Spread,” WSJ, March 16, 2007.

Without a precise timeframe for an “economic landing” and subsequent takeoff, our ability to profit from all the predictions about sub-prime defaults and housing valuations is, to put it mildly, limited. In fact, trying to make market calls based on economic forecasts represents a greater threat to portfolios than the underlying economic factors themselves, since, as money manager Peter Lynch observed, more money has been lost attempting to avoid bear markets than in bear markets.

In the end, the recent developments in the housing sector raise more questions than they answer. These developments may affect our short-term investment returns. But assuming we have laid a good foundation by clarifying our willingness and ability to absorb interim market declines, they should not affect long-term investment policy.

Thank you for reading. Until next month,

Milo Benningfield