COMMERCE BANK ECONOMIC REVIEW - AUGUST 2007

“Will subprime mortgages turn out to be the monster that ate the economy?”

By Joel L. Naroff, Ph.D.

Subprime, subprime, subprime. That is all we seem to hear these days. The stock market bounces violently every time a mortgage lender or hedge fund gets hit by subprime mortgage problems. The Fed is forced to express awareness that credit standards have been tightened because of the subprime concerns. All the while, the economy continues to grow somewhat sluggishly. So, will the subprime market become the monster that devours the economy? Probably not, but it will not go away without leaving its mark.

What is subprime? As explained by Department of Housing and Urban Development, typically, subprime loans are for persons with blemished or limited credit histories. The loans carry a higher rate of interest than prime loans to compensate for increased credit risk. 

As the housing bubble built, some lenders expanded the use of subprime mortgages to put people into homes that were otherwise unaffordable. These were often variable rate mortgages, and when the rates re-set, people saw their monthly payments jump. Not surprising, it turned out that many people who couldn’t afford prime loans also couldn’t afford the subprime loans. 

Now, there is fear that lenders – facing losses – will reduce their lending, creating a credit crunch. Credit standards were eased dramatically during the housing boom. Now that they are moving back toward more realistic standards, it seems as if credit has been reduced. But that is only because there was just too much credit issued.

The impact on the economy, however, could be real. Growth looks to be throttling back from the solid 3.4% second quarter pace – consumer spending has moderated. If credit is reduced to households and businesses that have good credit, a further slowing could result.

This has caught the attention of the Federal Reserve. The Fed did not change rates this month because members still felt inflation was the major threat. But at least it was noted that “financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing.”  Now that hardly tells us the Fed is ready to ease rates to help out the markets, but at least subprime has become an element in its decision making.

Can the economy absorb the problems being created by the subprime lending losses? Probably yes. Job growth remains decent, although nothing great. In July, only 92,000 new positions were added. On the surface that doesn’t look good, but there is an explanation. It seems the Bureau of Labor Statistics thought that local school districts hired tons of new people in June. In July, they discovered those jobs didn’t exist. So the job numbers were artificially high in June and low in July. Meanwhile, private sector continues to add workers at a decent pace. 

As long as jobs are added, households will have money to spend. They may not shop ‘til they drop, but they likely will visit the malls. Also, world growth remains strong and companies that do business globally are doing well. The economy may expand modestly the rest of the year, but unless there is a major credit crunch, a serious downturn should be avoided.

Joel L. Naroff, Ph.D., is Chief Economist for Commerce Bank. Commerce Bank, America’s Most Convenient Bank, is a leading financial services retailer with nearly 450 convenient stores in New Jersey, New York, Connecticut, Pennsylvania, Delaware, Washington, DC, Maryland, Virginia and Southeast Florida. Commerce Bancorp (NYSE: CBH) is headquartered in Cherry Hill, NJ and has more than $48 billion in assets. For more information about Commerce, please visit the company’s interactive financial resource center at commerceonline.com.