Resident Fellow Desmond Lachman

On hearing Federal Reserve officials reassure the public that the present problems in the US subprime mortgage market are nothing about which to worry, one cannot help feeling that one has been to this movie before. For it was as recently as 2000 that many of the same Federal Reserve officials were assuring the public that the bursting of the stock market bubble was something that would not have a meaningful macroeconomic impact. And they continued doing so for many months before the Fed was forced to cut interest rates aggressively to prevent the stock market debacle from causing a deep recession.

Federal Reserve reassurances to the contrary, today's acute problems in the U.S. subprime mortgage market are better viewed as the canary in the coal mine forewarning about very much broader housing market problems to follow. For the same forces that drove up U.S. home prices to dizzying heights over the past six years are beginning to operate in reverse. By so doing, those forces will inevitably lead to a prolonged reduction in home prices that could have potentially damaging consequences for the overall US economy.

Robert Shiller, the renowned Yale University student of the U.S. housing market, has correctly observed that the 75 percent run up in home prices in constant dollars between 2000 and 2006 has no remote precedent in the past 120 years. For never before have so many factors conspired to fuel such a pronounced and prolonged housing market upswing.

Among the more important factors underlying the U.S. housing boom was the ample provision of liquidity by the Federal Reserve in the aftermath of the bursting of the equity bubble in March 2000. Not only did the Federal Reserve cut interest rates by 550 basis points following the stock market crash, but it kept interest rates at 1 percent for a prolonged period of time.

Adding fuel to the boom was a remarkable relaxation in lending standards and the introduction of an array of exotic mortgage instruments aimed primarily at those who previously were excluded from the housing market. No longer did borrowers need good credit records or income verification to obtain housing credit. No longer did they need to be burdened in the initial phases of the loan with either high interest or amortization payments as adjustable rate mortgages (ARMs) or negative amortization loans became the norm. This gave rise to a veritable explosion of subprime mortgage lending, which in 2006 accounted for around 20 percent of all mortgage lending.

As the hapless owners of the approximately $1 trillion in subprime mortgages are now painfully learning, the same factors that fueled the earlier run-up in home prices have gone fully into reverse. The Federal Reserve has returned interest rates to more normal levels, adjustable rate mortgages are now resetting at higher rates, and speculators, who accounted for as much as 25 percent of home purchases in 2006, are now rapidly exiting a falling market. To make matters worse, the regulators, who were pretty much asleep while the party was in full swing, have now taken it upon themselves to substantially tighten lending standards at precisely the time that the market has already turned. Against this backdrop, it is hardly surprising that home prices at the national level, which were increasing at an annual rate of 15 percent as late as mid-2006, have now begun to decline.

In gauging where the U.S. housing market might now be headed, it is well to reflect on the fact that the abrupt turn in the subprime housing market occurred at a time of high overall employment and a reasonably strong economy. Federal Reserve officials should now be asking themselves what would happen to the whole of the housing market were the economy to weaken. More important still, they should be asking the related question as to how a declining housing market might impact the overall economy.

Raising these types of questions would lead the Federal Reserve to a very much less sanguine assessment of the potential economic fall out from the U.S. housing market correction than the reassuring one that they are now offering the public. For many of the same poor lending practices involving adjustable rate and negative amortization mortgages in the subprime market were commonplace in the prime mortgage market. And these practices will be sorely exposed as housing prices continue to decline under the weight of an already large inventory overhang and the unwinding of speculative positions.

Desmond Lachman is a resident fellow at AEI.