Thomas Zimmerman, Nouriel Roubini, and Alex J. Pollock

In late 2006, it became apparent that the U.S. housing market bubble had been deflating. Subprime lenders--those who lend to the riskiest, least-creditworthy borrowers--have been hit especially hard, with some of the largest subprime lenders entering bankruptcy. The flow of easy credit which fueled the recent housing boom is shrinking. On March 28, AEI and the Professional Risk Managers' International Association hosted an event to examine the implications of a deflating bubble. AEI's Alex J. Pollock moderated the panel discussion.

AEI's Desmond Lachman addressed the past, present, and future of the crisis. Between 2000 and 2006, housing prices rose by 80 percent--a rate without precedent. Home ownership also rose rapidly, fueled by abnormally low interest rates, "lending to people who really are not creditworthy," and "exotic lending instruments." The housing bubble was compounded, Lachman said, by increased speculative activity. As subprime lending weakens, this leaves the U.S. housing market in a situation of oversupply, with rising vacancy rates, reduced housing demand, and falling home prices. Lachman said we are "in for a pretty rough ride," as a 30 percent downturn in housing activity could reduce GDP growth by 11/2 percentage points and cause attendant problems in the financial sector.

Nouriel Roubini of New York University argued that we are "nowhere near the bottom of the housing recession" and that this could be the worst housing recession since the 1960s. He also said the housing recession--a result of "reckless lending practices" such as expanded adjustable-rate mortgages (ARMs) and zero down-payment loans--will spread to the whole economy. "We are in a subprime economy," he said, tying lending practices in the subprime mortgage market to lending practices in the auto loan and credit card industries. He suggested that a hard landing is virtually unavoidable, and that the Federal Reserve will be powerless to prevent the coming recession.

Speaking on bank performance and credit quality, R. Christopher Whalen of Institutional Risk Analytics said default rates in commercial lending and mortgages currently "remain well below long-term averages." But because big banks such as HSBC and Wachovia have entered the subprime lending business, increased defaults on subprime loans might affect other financial sectors more severely, making the "scope of the problem embedded in the financial system unknowable." Whalen said default rates will continue to go up, despite lower interest rates.

Thomas Zimmerman of UBS Investment Bank said the recent jump in "early payment defaults" (EPDs) caught the financial sector by surprise. Previous EPD rates were below 1 percent; now they range from 6 to 8 percent. These "irregular default statistics" expose how ARMs are the "wrong vehicle" for subprime borrowers, he said. With only 15 percent of mortgages subprime, and only a 20 to 30 percent default rate on all subprime mortgages, the affected borrowers will be hurt, but "most people will not feel it." He said the correction will be limited to the housing sector.

AEI scholars, including Pollock, Lachman, and John H. Makin, have written extensively on this subject, addressing how the subprime lending crisis affects the housing market, access to credit, interest rates, risk, and the potential for a recession. In his April Economic Outlook, Makin wrote that slowing growth coupled with the housing slowdown signals a possible recession in 2007, and that a brief recession would be a small price to pay for continued low inflation.

For a video, summary, and the presentations from this conference, visit www.aei.org/event1468/. For work by AEI scholars on the subprime lending crisis, visit www.aei.org/subprime/.