Thursday, August 9, 2007

Mortgage Market Woes: Credit Crunch

by Amy Lillard

This year has been a year of ups and downs for the housing market. In our continuing series, we chronicle news affecting the housing market and its major players.

In all the insider talk about this year's mortgage woes, we've heard a lot of new terms. Subprime market. Government-sponsored enterprises. And then there are the copious economic reports with titles of varying complexity.

Add a new term to the list. Recently, there have been rumblings of a "credit crunch" as the effects of the subprime market implosion continue to be felt.

What's a credit crunch? Technically, it's an economic condition where investment capital is difficult to obtain. Banks and investors get leery of lending money to corporations, meaning higher prices for loans for borrowers. What this means in the greater context is an extension of or a harbinger of a recession.

Many industry analysts and corporation owners are saying a credit crunch is in progress or near. After years when companies and private equity firms had no limits and were able to obtain trillions of dollars of debt at low interest rates, the money may be drying up. This affects many parts of the economy. If cheap debt is restricted, it means an end to activity funded by cheap debt. This means businesses are scaling back products and expansion, meaning layoffs and lowered share prices.

It all started with the subprime market, where lenders offer mortgages to borrowers with credit that's less than ideal. For years the subprime market skipped along robustly. Mortgage lenders in the subprime market often sold the debt to a big Wall Street bank or other entity, where millions of these mortgage debts were pulled together into collaterized debt obligations (CDOs). These were sold to investors, such as hedge funds. A subprime loan became collateral for some other debt elsewhere in the world.

Since a subprime loan is lumped in with other types of debt, if an individual borrower defaults on the loan, the default shouldn't affect the overall CDO. However, the highly fluctuating and often unfair loans have meant an increased number of defaults in the last year. When a large number of borrowers default, trouble begins, and did begin this year. Over time and increased defaults, along with slipping house prices, investors have lost faith in CDOs. Demand has dropped drastically, and the value of the CDOs has collapsed.

How does this relate to a credit crunch? When the subprime market first started its sickening drop early this year, many lenders and regulatory agencies increased their scrutiny of the lending procedures in the market. As more and more companies have lost funds due to chain reaction of subprime defaults and CDOs, scrutiny increased. Now, many say, lending companies and banks are increasingly wary of extending loans to individuals and corporations. And when loans are given, they include higher interest rates than in the past few years.

All of this came to a head last week with the plunging stock market. Comments from a Bear Stearns executive indicated what many in the industry already believe - we're in the midst of a widening credit crunch. The Bear Sterns CFO described the situation in the credit market the worst he'd seen in 22 years.

It usually takes hindsight to definitively point out the beginnings of a recession or a credit crunch. Investors know that the next few weeks will feature volatility in the stock market due to credit worries and upcoming economic figures. Industry analysts keep their eyes on indicators like increasing company bankruptcies and stricter regulations. For the rest of us, we must sit and ride the tide of what could be a slowing economy.

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