The Credit Crunch That Sank the Economy?

This subscription-only Wall Street Journal editorial from last week got most of the story right, but missed a couple of points:

….. we finally have a threat that really does bear watching — namely, a potential credit crunch precipitated by the housing downturn and rising default rates. As Federal Reserve Chairman Ben Bernanke noted in his Senate testimony this week, the economic damage from the real-estate slide has so far been contained to housing. But in addition to the pain that homebuilders have experienced, banks and mortgage brokers are increasingly feeling the pinch, especially in the sub-prime sector. And in a perverse sort of populism, lawmakers are making noises about reducing access to credit for the riskiest borrowers, which would only exacerbate the crunch and could help take the economy down into recession.

The delinquency rate on sub-prime mortgages, now above 10%, is near record levels…..

….. This accumulation of bad loans represents a crack in the foundations of the recovery. Typically, a housing downturn and the credit problems that accompany it are a result of underlying economic weakness, rather than their cause. The economy slows, people lose their jobs and are forced to sell under duress lest they default. The distressed selling drives prices down. But in this case, it may work the other way around.

The Fed’s remarkably easy monetary policy helped goose house prices over several years. In turn, a large number of first-time buyers took advantage of low mortgage rates, especially on adjustable-rate loans, to stretch their buying power in the hopes of leveraging their way up the home-buying ladder. But someone finally blew the dog whistle in late 2005, and the buying dried up.

Now the housing market is flat to down across most of the country and loans with adjustable rates are adjusting upward. So even with unemployment low and the economy still humming, marginal buyers can suddenly find themselves forced to sell. And if they had little equity to begin with, they may not have much money left after they sell — if they can sell at all. If they can’t, they fall behind on their payments and the banks have to book the loans as delinquent.

….. The unknown is how far the credit contagion will spread. While rising, overall delinquency rates are still fairly low. But if banks continue to be hit by defaults, it may constrain their lending in other areas. Credit spreads, which have remained remarkably narrow, could widen. Meanwhile, Congress’s newfound preoccupation with “predatory lending” could, if it leads to changes in the law or in tough lending standards, increase the credit squeeze currently beginning to be felt. Decreasing consumer access to credit would in turn cast a pall over consumer spending and add another drag on the economy.

We aren’t joining the partisans at certain newspapers who have predicted recession each of the last four years. The labor market remains healthy, the consumer resilient, business investment robust and equity markets buoyant. But this certainly is no time for Congress to add to the risks of a credit crunch by committing such policy blunders as raising taxes, imposing trade barriers or punishing foreign investment in the U.S.

The Journal’s editorial is fine as far as it goes. But it forgot to mention the role the behemoths of loan securitization, namely government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, played in all of this:

• Those two GSEs lowered the credit scores and relaxing related documentation standards for “conventional” and sub-prime mortgages to the point where clearly unqualified borrowers were getting “conventional” treatment and borrowers who barely had a pulse credit-wise were getting sub-prime applications approved. A contact of mine in the lending industry told me in mid-2005 that the threshold for conventional approval was lowered from a credit score of about 670 to about 630, and for sub-primes dropped from about 630 to 590.
• Lenders aren’t blameless, because they “should” have been evaluating borrowers to prevent the most obvious train wrecks in-waiting from happening — independent of whether the relaxed “Fan and Fred” models said that these borrowers could afford the loans being offered. There’s precious little evidence that much of this happened.
• And, of course, borrowers themselves deserve a substantial share of the blame for not understanding what they were getting into.

I agree that at the moment the possible credit crunch in mortgage lending probably won’t lead to a recession; the non-housing economy is growing at over 4%. But the hardships many borrowers are enduring could have been prevented, and should have been.