Subprime Mortgage Crisis Threatens Construction
Jim Haughey -- August 21, 2007
Problems in Financial Markets Cause RCD to Lower Construction Forecast
The risks to construction from the subprime mortgage market collapse are growing, but still appear to be containable. However, it is not yet certain that it will be contained with minimal damage to contractors and their suppliers.
Reed Construction Data (RCD) is slightly marking down the construction spending forecast for the rest of this year, primarily in housing.
Similar to S&L Collapse, Aftermath will be Long and Ugly
The worldwide flight of investors from U.S. non-traditional mortgage loans still has financial markets in turmoil. Investors are battling each other and mortgage brokers to sort out who will end up taking the losses from mortgage defaults and, more importantly, the losses from marking down the asset value of loans now judged more risky than when they were made.
The outlook is that the turmoil in trading rooms will continue for a few more days, perhaps a few more weeks. However, as with the S&L collapse a generation ago, the aftermath will be long and ugly and act as a depressant on investing in mortgages for many years.
Multiple Risks to Building and Facility Investment
There are multiple risks to building and facility investment as the financial crisis plays out. Some are happening already, although it is not yet clear how large the negative impacts will be. Others are inevitable, but at this point the damage looks to be small.
- A further reduction in homes sold with non-traditional mortgages is underway and cannot be stopped. Many of the specialists in these types of mortgages have collapsed for lack of access to credit. Traditional brokers who originated some of these mortgages have withdrawn from the sub-prime and Alt-A markets. These mortgage instruments will not return for many years. The estimated 75% to 80% of households who got these expensive loans and paid them on time are now locked out of the housing market.
- Another surge of recently bought homes thrown on the resale market is underway and cannot be stopped, as homeowners default when interest rates reset higher.
These hits to the housing market are the result of the restructuring of mortgage finance. Most of what is left of the subprime and Alt-A mortgage market is disappearing during July and August. Alt-A mortgage loans fall just short of the credit or collateral requirement of Freddie Mac and Fannie Mae, which buy the bulk of mortgage loans from brokers. These loans, or the bonds that fund them, had been bought by hedge funds and other investors who now refuse to buy them or offer much lower prices to assure their depositors and investors that they are investing prudently.
Three Spillover Hits in Other Residential and Commercial Mortgage Markets
Three spillover hits result from the cast flow problems of the usual lenders. Their cash has been depleted by investor and depositor withdrawals and their own asset writedowns. They are reluctant to buy mortgages while asset prices are in flux.
- The purchase of expensive homes with jumbo mortgages (more than $417,000, so that Freddie Mac and Fannie Mae cannot buy them) has been disrupted. Some purchases are being delayed; others cancelled. This negative impact should be brief. But it is severe in regions with the highest home prices, such as California, the Northeast and the South Florida beaches.
- Commercial mortgage financing has also been disrupted, but the impact is minimal and likely to be relatively short in duration.
- There are few signs yet of credit access problems in the prime residential mortgage market for “conforming” loans, intended to be sellable to Freddie Mac or Fannie Mae. But there likely will be some instances of loans cancelled before closing and applications denied for lack of access to credit by the mortgage broker.
Indirect Impacts — Possible Credit Crunch and Loss of Consumer Confidence
There are also serious indirect impacts which have not yet begun. Today, their probability and impact is unclear because they depend on reactions to the current crisis that is currently only in the financial and U.S. housing markets.
- A credit crunch is the most serious risk, but also the least probable. Credit crunches occur when activities throughout the economy have to shut down or scale back for lack of credit, even though credit ratings may be good. Already, quick, aggressive provision of additional funds by the Federal Reserve Bank has reduced the probability of a credit crunch to minimal. However, should one occur, an instant recession would result with the usual plunge in investment spending.
- A 9- to 12-month slowdown in the U.S. economy could occur if people become too pessimistic about clearing up the problems in financial markets. Remember what happened several times when oil prices surged higher and also as the prelude to the two Iraq wars. A plunge in spending confidence in an uncertain and threatening situation produced a spending slowdown within a few months that persisted for many months after the threat passed.
- A slowdown in the U.S. economy could also be set off by a credit crunch or a collapse of confidence in another country. Thailand set off a slowdown in the U.S. economy in 1987. Once again, Asia is the most likely place for this to happen.
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