Although the causes are well known, the effects of this mortgage meltdown are hotly debated. Will droves of Americans be driven from their homes, as some have suggested?¹ Will this crisis spill over into other sectors of the economy, as former Fed chairman Alan Greenspan speculated?² What implications will this have for your portfolio?

Despite the panic this crisis has caused, its consequences may not be as dire as some have predicted.

This storm has been brewing for a while. In the fourth quarter of 2006, late payments on U.S. subprime mortgages reached a four–year high.³ In the past year, four home lenders have gone bankrupt and another 26 have either closed up shop or sought buyers.⁴

The subprime lending industry grants mortgages with higher interest rates to homebuyers with low credit scores who typically buy their houses with little or no money down. The loans are considered “subprime” because they are offered at rates above the prime rate, a benchmark banks use for establishing interest rates. Often, these loans come in the form of an adjustable rate mortgage (ARM), whose interest rate fluctuates periodically based on an index. Previously, the subprime market had been growing steadily with the housing boom. In the last two years, subprime mortgages accounted for about 20% of all mortgages, and in 2006 40% of all ARMs and interest–only mortgages were subprime.⁵

The causes of this mortgage market maelstrom are widely agreed to be a confluence of falling housing prices and rising interest rates. As the housing market has cooled off, the median home price has fallen in 9 of the last 10 months.⁶ The rise in interest rates means that mortgages with adjustable rates get more expensive, pushing defaults higher as many with subprime mortgages cannot afford to make their mortgage payments. A higher rate of foreclosures means more homes will be on the market, increasing supply and therefore, potentially exacerbating the decline in housing prices. However, these declines mark only a 0.3% change from the previous year.⁷

In 2006, a drop in residential construction cut GDP growth by a full percentage point.⁸ Some experts predict that this trend could continue in 2007. However, outside declines in the housing and remodeling industry, experts don’t foresee much collateral damage in the rest of the economy.⁹ Rising foreclosures and falling house prices may affect economic growth, but the effects should be minor.

Additionally, the falling home prices and rising interest rates could slow the amount of borrowing Americans do through home equity loans, second mortgages, and cash–out mortgage refinancing.

Although it may lead to problems in the mortgage lending industry, many economists see the troubles of the subprime market coupled with falling house prices as an inevitable market fluctuation. Whenever prices soar as they did in the housing market, the market is bound to correct itself in the short–term. Historically, despite short–term declines in the housing market, the general trend in home prices has been upward. In fact 2007 may be the first year in 40 years to show a decline in median housing prices.10 It is important to focus on a long–term strategy and not get caught up in short–term market fluctuations.

¹ Financial Times, March 22, 2007.
fn2. Reuters, March 15, 2007.
fn3. fn4.) Bloomberg, April 2, 2007.
5, 8) Standard & Poor’s, March 2007
6–7, 10) CNNMoney, April 24, 2007
fn9. Standard & Poor’s, April 2007

For Region: Chicago

• Greg Farrall
• SVP Lakeside Wealth Management Group, LLC

Greg P. Farrall is a fully licensed financial advisor with Lakeside Financial Group, LLC. Greg has extensive experience in the equity derivatives markets after having served as partner with multi-million dollar investment firm, Rubicon Investments at the Chicago Board of Options Exchange. Prior to joining Lakeside, Greg spent thirteen years as a floor trader which helped him gain expertise in overall market investing. He has traded through such market events as the devaluation of the peso, healthcare bear market, the dot-com boom and the dot-com bust. He holds Series 7, 63, and 65 Licenses, as well as Life and Health Insurance Licenses.