Subprime Mortgage Woes Spread; Forecasts for Home Prices Cut

Economists said the turmoil surrounding these risky loans is likely to spread to the broader mortgage market, a WSJ.com survey finds. The extent of any spillover to the housing market remains unclear.
By: Phil Izzo: The Wall Street Journal Online
Most economic forecasters in a new WSJ.com survey believe recent turmoil in the subprime mortgage market is likely to spread to the broader mortgage market and they expect a widely followed index of home prices to fall this year. But they still think the U.S. will avoid a recession and even a significant rise in unemployment.

"The markets may have over-reacted," said John Lonski of Moody's Investors Service. "Only businesses significantly exposed to subprime will be hurt. Mortgage repayment problems aren't as widespread as we are led to believe. If most people were having trouble paying the mortgage, it would lead to declining consumer confidence and we haven't seen that."

Of the 60 economists surveyed, 32 said it is either "very" or "somewhat" likely that the intense and speedy unraveling of the market for subprime mortgages - home loans made to people with poor credit histories - will spill over to the rest of the mortgage market.

But 26 said that's not likely. Two didn't respond.

The woes of the subprime mortgage market are the latest chapter in deterioration of the housing market. Concerns about the sector and the ripple effects on the economy have been blamed for gyrations in the stock market the past week, including a 2% drop in the Dow Jones Industrial Average Tuesday.

But just 22% said difficulties in the subprime market have caused them to downgrade their economic forecasts and, by a 4-to-1 margin, they agreed with the statement that "the worst of the housing bust is behind us."

The economists slightly reduced their forecasts for the economy this quarter but still expect moderate growth all year, at around a 2.3% rate this quarter, increasing to 3% by year-end - with unemployment rising just a bit. They put the odds of recession in the next 12 months at about 25%, slightly less than former Federal Reserve Chairman Alan Greenspan's odds of about 33%. The survey was conducted March 9-13.

The economists are markedly more optimistic - both about the U.S. economy and about the stock market - than the public is, as measured in a recent WSJ/NBC News poll.

But, as is often the case, there is disagreement among the economists about the risks that the subprime market poses to the overall U.S. economy.

"Mortgage credit-quality problems go well beyond the subprime sector," wrote Jan Hatzius, chief U.S. economist at Goldman Sachs in New York, in a research note. "The underlying problem is not the subprime market per se, but the reset of large quantities of adjustable-rate debt -- some of which is classified as subprime some as prime - to higher interest rates in an environment of flat or falling house prices in most of the United States."

Mr. Hatzius notes that the so-called teaser rate, or low initial rate on adjustable-rate mortgages, expires sooner for subprime mortgages. This implies that mortgage-holders with prime ARMs may come to experience the same woes currently making waves in the subprime sector.

The extent of any spillover from subprime to the broader housing market remains unclear. "You can tell a lot of scary stories," said Richard DeKaser of National City Corp., "but they're not broadly accurate. We're still talking about a small segment of the nation's homes that are affected." According to the American Housing Survey for 2005, the most recent date for which data are available, 33% of all homes are owned outright and 57% have traditional mortgages, leaving just 10% potentially affected by ARM woes.

The subprime concerns are also likely to weigh on prices, according to Mr. Lonski. "Home sellers will be forced to accept lower prices in the spring. The subprime issue reinforces that home prices would be subject to price recession, creating an expectation of lower prices among buyers."

Economists' expectations for home prices dropped from the previous survey. On average, they see a 0.77% decline in prices, measured by the government's Office of Federal Housing Enterprise Oversight index, in 2007, compared with their forecast in a survey last month for a 0.44% decline. Of the 55 economists who answered the question, 34 predicted prices will be flat or will decline. The index, which tracks price changes in repeat sales or refinancings on the same properties, has never posted a year-to-year decline.

The economists were split on whether regulators should have acted sooner in the subprime mortgage market. Twenty-eight of the respondents said "yes," while 24 said "no." Robert DiClemente of Citigroup contended that the problem wasn't centered on regulated institutions.

But some economists put part of the blame on the Federal Reserve. "Was it necessary to cut the fed funds rate to 1%, supercharging the housing recovery?" said Mr. Lonski. The June 2003 move, which ended a three-year cycle of rate cuts, was aimed at fostering economic growth and contributed to continued low mortgage rates.

Three-quarters of the economists - 40 of 54 who responded - said they believe interest rates would be at the same level today if Mr. Greenspan were still chairman of the Fed instead of Ben Bernanke. Nine said rates would be lower now, while five said rates would be higher now.

Mr. Greenspan has roiled the markets this month with his prediction that slowing growth in corporate profit margins means that the risk of recession is greater than many believe. Amid the stir Mr. Greenspan caused, about a quarter of the economists said he should refrain from making public comments about the economy, while the rest said he should speak his mind. "I'd prefer more Greenspan commentary, not less," said Bruce Kasman at JP Morgan Chase. The economists were about evenly split on his assessment of profit margins.

Among other findings in the survey:

• Just under half of the economists 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. In the latest WSJ/NBC poll, 49% of Americans said they expect the economy to remain the same, while 31% said they expected things to get worse and just 16% said they expect improvement. The economists are also more optimistic about the stock market. Three-quarters of the economists expect stocks to rise. Less than half of Americans feel the same way.

• Just 17 of the 60 economists surveyed expect the Federal Reserve to move the fed-funds rate from the current level of 5.25% by June. On average, the economists expect a quarter-point cut by December.

• Inflation forecasts were moved slightly higher, with consumer prices expected to rise, on average, 1.8% in May and 2.5% in November compared with earlier forecasts of a 1.6% and 2.4% increase, respectively. A possible contributor may be oil prices, which are now expected, on average, to be $59.26 a barrel in June compared to a forecast of $57.98 in the February survey and $59.37 in December, up from $58.72 in the February survey.