September 2007

The Financial Market Credit Crunch
By Sara Sutachan, Senior Research Analyst & Robert Kleinhenz, Ph.D., Deputy Chief

Since the start of the year, the housing market has faced adverse effects from the mortgage market turmoil, as lenders began to tighten their credit underwriting standards amid rising default rates in sub-prime and non-prime mortgages. The results became quite apparent in the second quarter, as sales slipped from a plateau of roughly 447,000 sales that prevailed for several months to the 360,000 to 370,000 range.

Seasonally adjusted, annualized sales of existing detached homes fell further in July to 350,980 units, down 3.7 percent from a month earlier when sales were 364,280 and down 22.7 percent from a year ago when sales were 453,980. From the period January through July, sales were down 20.1 percent from the same time last year. The statewide median price continued to increase slightly to $586,030, a 3.2 percent year-to-year increase. As mentioned in earlier articles, this headline increase is not telling the whole story of what is happening in different market segments.

The drop-off in July activity resulted in part from further tightening of credit underwriting standards among lenders since the beginning of the year. According to a recent set of survey results from the Federal Reserve (Fed), banks had tightened their belts even more over the summer than they had at the beginning of this year. Of the banks surveyed, the majority of banks that offer sub-prime or non-traditional (also known as Alt-A loans or loans with limited income verification required) mortgage loans have either tightened their credit standards considerably or somewhat. This translated into fewer loans being given out to potential homeowners.

To make matters worse, a credit or liquidity crunch emerged as a result of rising defaults in non-prime loans, loans that had been flying off the shelves in the last few years. In July, investors lost confidence in any financial instrument tied to mortgages, and a widespread sell-off of mortgage-backed securities ensued. Those securities are what give banks the flexibility to spread the risk of underwriting the loans they provide to consumers over a number of investors. Without this flexibility, the lending institutions and banks no longer had funds readily available to lend to consumers, further constraining potential homeowners' ability to own a home. The lack of funds from investors created an extremely tight mortgage market situation and a serious liquidity problem for banks and other lenders who were funding home mortgages. Even prime borrowers have seen their loans go unfunded during the last several weeks.

Amid all of the financial market turmoil, the Fed has been watchful and has taken actions to calm some of the market pressures by first pumping millions of dollars into financial markets and lower the discount rate (the rate the Fed charges banks directly), and more recently dropping the federal funds rate (the rate on overnight loans between banks) by one-half of one percent to help promote financial stability and negate any downward pressure it may cause on economic growth.

Tighter credit underwriting standards coupled with the credit crunch will impact the housing market in the form of fewer closed escrow home sales in the coming months. Seasonally adjusted annualized sales are expected to decline further than their current pace as homes continue to fall out of escrow. The impact of the credit crunch should level off in the next 60 to 90 days as investors start to move back into a comfort zone with mortgage related securities and asthe Fed continues its efforts to stabilize financial markets.


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