Investors beware as recession risks rise

Serious Money:Volatility has returned to the world's financial markets and the "dash for trash" may finally be at an end. Global stock markets had been on a relentless upward march since last summer and US stock prices had gone a record 228 sessions without a daily pullback of 2 per cent or more, writes  Charlie Fell.

Stock price weakness emanating from China and disappointing economic data from the US led to the worst week for equity investors in four years. The cheery consensus on Wall Street, which called for nothing worse than a soft economic landing in 2007, has been called into question as recent economic data revealed that the preliminary report of accelerating growth in the fourth quarter of 2006 was wide of the mark while the housing market continues to deteriorate. Recession risks are rising and heightened volatility is here to stay.

Fourth-quarter GDP growth was revised down from 3.5 per cent to a sluggish 2.2 per cent. The magnitude of the revision has been matched or exceeded only seven times in the past 30 years and the picture of an economy rebounding and gathering momentum has been erased. Housing market data revealed that new home sales dropped more than 20 per cent year-on-year in January while the inventory of unsold homes increased to almost eight months as compared with an average of just four months from 1997 to 2005.

Not surprisingly, Ben Bernanke, chairman of the Federal Reserve, has identified the housing market as the biggest risk to a soft landing, noting that the "ultimate extent of the housing market correction is difficult to forecast and may prove greater than we anticipate". The sub-prime mortgage market, which provides home loans for individuals with impaired or limited credit histories, is in meltdown. Defaults are soaring and more than 30 sub-prime lenders have shut down or filed for bankruptcy recently.

More than 10 per cent of all sub-prime mortgages are delinquent by 90 days and the Centre for Responsible Lending estimates that one out of five sub-prime mortgages originated during the past two years will end in foreclosure. This is worse than the "Oil Patch" disaster of the 1980s. Ultimately, more than two million households will lose their homes.

Optimists believe that the collapse of the sub-prime mortgage market will have limited impact on the overall economy. This is wishful thinking. Sub-prime mortgages have become a major component of home financing. The sub-prime home loan market grew from $35 billion in the mid-1990s to $665 billion in 2005, a period in which its share of total mortgage originations jumped from less than 10 per cent to almost 25 per cent. One in eight outstanding mortgages is sub-prime today as against one in 12 in 2001. Furthermore, the volume of near-prime mortgages has also soared such that the prime home loan market accounted for just 40 per cent of total originations in 2006.

Excess liquidity and rising house prices saw mortgage lenders engage in a race to the bottom that is now coming home to roost. It has been surprisingly easy for individuals purchasing a new house to borrow money. Homebuyers are no longer required to make significant downpayments. Indeed, more than 5 per cent of all residential mortgages since 1999 have been originated with no equity or had negative home equity.

Additionally, "stated income" loans, where the income stated on the loan application is not verified by the mortgage providers, are commonplace. More than one-third of all mortgages today are originated without income verification. Furthermore, prospective homeowners have been enticed by offers of ultra-low teaser rates and/or adjustable-rate mortgages with minimal down-payments. Unfortunately, roughly $1.5 trillion of adjustable rate mortgages will reset this year placing further upward pressure on default rates.

Households have become increasingly financially constrained in recent years as median income levels have languished. Mortgage providers have encouraged middle and low-income families to borrow against their homes to cover the gap between household income and spending.

The Federal Reserve reports that total mortgage equity withdrawal increased from $289 billion to over $900 billion between 2000 and 2005. Homeowners have become increasingly used to spending gains that only exist on paper and, in 2006, more than 70 per cent of all refinancing activity resulted in a 5 per cent or higher loan amount.

As the housing market continues to weaken, many borrowers are likely to find that they owe more money than the house is worth. The implications for consumer spending are clear.

The recent setback in financial markets has put fundamentals back in the spotlight. Housing market indicators suggest that the US economy is on the road to recession. The probability of an economic downturn within the next 12 months is now 40 per cent. The blue-sky optimists believe the probability is closer to 20 per cent. Nevertheless, for an economy that has endured just eight months of recession in the last 24 years, even the optimists' estimate warrants caution. Volatility will persist at higher levels as the bull market enters its latter stages and investors should increase their allocations to low-risk assets.

• Charlie Fell is an independent consultant and lectures in finance and investment in UCD and the Institute of Bankers in Ireland.