The Sub Prime Lending Debacle and the Stock Market Downturn

During the last couple of weeks the Dow Jones industrial average has tanked to the tune of over 1,000 points. Many analysts reason this abrupt market downturn has been caused by a sudden increase in sub prime lending defaults. Can a tight mortgage market shoot down the whole economy, or is this issue being overblown?

The Real Estate Bubble

The real estate market has had an enormous run up over the last 14 years. During the last few years, the accelerated increase in real estate prices has been seen as unsustainable. Many have referred to this unsustainable increase as "the real estate bubble." Most of us who have followed the real estate trend concluded that since no financial market can continue straight up forever, this real estate bubble would someday burst. Well, it looks like the real estate bubble has at long last burst.

Sub Prime Lenders' Loans

What made this particular real estate downturn so inevitable was some of the peculiar, and reckless mortgages that sub prime lenders made in the last few years. These reckless loans helped stoke the hot real estate market, but they were more prone to default than regular mortgages. One type of reckless loan pushed by these lenders was the negative amortization mortgage.

With a negative amortization mortgage, a borrower gets to pay very low monthly payments for the first few years of his mortgage. After the first few years, the monthly payments skyrocket to maybe 2, 3, 4 or 5 times their original, very low amount.

Of course, most people are unable to pay this new increased payment and when they are unable to refinance or sell their houses, they default. When people start to default on their mortgages in large numbers, lenders who originated these mortgages namely sub prime lenders will be hurt financially. In other words, negative amortization mortgages have come home to roost right on top of the foolish lenders who approved them!

The Stock Market

The stock market is prone to dips and sell-offs when talk of terrible financial situations abound. The sub prime lender debacle has caused such talk. However in reality, it looks like economic conditions haven't changed much.

Nothing has happened to our inflation rate, in fact, it's getting better. There has been no recent increase in unemployment, and certainly the growth in the USA remains very strong. Interest rates are, actually, trending downward.

On top of these conditions, 97.4% of all mortgages are not in trouble. It's as if there is a black cloud hovering above the market and when news reporters look toward this cloud, all they seem to be able to find is the sub prime lender fiasco.

The Federal Reserve's Response

At first, Fed Chairman Ben Bernanke, responded to the sub prime lender problem by doing nothing. With the economy continuing to expand and inflation under control, usually the Fed doesn't move on the discount rate. After a wild ride for the last several sessions, however, the Fed lowered the rate one-half percent on Friday, August 17.

Note that lowering the discount rate doesn't always initiate a stock market rally. Sometimes this move is seen as inflationary and the market reacts negatively. So, it's hard to know for sure, where this move will lead us.

At first glance, you would think the market's response to the rate being lowered was emphatically positive because there was a 233-point upward move in the Dow Jones Average on Friday. However, remember, the Dow rose over 300 points on late Thursday which was before the Fed moved.

The Housing Market

Housing slumps can certainly portend to a stock market slump. When houses stop selling, there is no longer a need to build them. This puts many construction workers out of work and many construction companies in the red. When the unemployment rate goes up and one segment of the economy stops making a profit, it can weigh heavily on the stock market.

So, We're Entering Into a Bear Market, Right?

It may turn out there is a bear stock market looming, but I don't believe the bull market has ended just yet. It could be, with sub prime lenders out of business, mortgages may become more difficult to come by and that will add to the many reasons the housing market will stagnate for a while. Given enough time, a slow housing market could slow the stock market. However, what's happening right now in the sub prime lender market is not cause for major concern.

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