Where is the risk in global financial markets?

Secondly, there is evidence that the 'wealth effect' acts in an asymmetric manner, so that, while large rises in housing wealth may induce rising consumption, falls in housing wealth do not produce a big negative impact. In this context, it is worth noting that even during the US recession of 2001-2002 when household financial wealth dropped sharply, real consumption continued to grow at around a 2% pace. It is also worth noting that while mortgage equity withdrawal fell to just 4.6% of disposable income in Q1 - the lowest rate for six years - real consumption was more than 3% higher than a year before.

The third and final channel whereby housing market weakness might impact the wider economy is the financial channel, whereby losses on mortgage loans lead to lenders tightening up credit standards, choking off new credit not only to the housing sector but other sectors as well. This brings us on to the recent problems in the subprime mortgage sector. Subprime lending almost tripled in 2004-2005, and recently delinquency rates on these loans have risen significantly to around 14% in Q1 and to even higher rates among the most recent vintages of these loans. The delinquency rate looks likely to exceed its previous peak in 2002 and more than 20 lenders have gone bust, sparking concerns about knock-on effects into the mainstream mortgage market and the broader credit market.

Subprime mortgage weakness could prompt wider financial market distress...

How justified are these concerns about property markets? The subprime market remains small subprime and Alt-A mortgages accounted for 14% of total US mortgage lending outstanding at end-2006. As a result, while delinquency rates among subprime loans have risen notably, overall mortgage delinquency rates have risen only slightly to 4.8% in 2007Q1 from 4.4% in 2005Q3. Prime loan delinquencies rose just 0.24% to 2.58% over the same period.

There is also a question-mark over where exactly the bulk of the losses from subprime mortgages will fall. Banks do not on the face of it appear to be the main likely losers - although some big institutions have been significant players in the subprime market, around 70% of subprime mortgages were originated by specialist lenders. It should also be noted that subprime originations have dropped significantly since 2005, and that the Fed loan officers' surveys this year have shown the sharpest tightening in mortgage lending standards since 1990.

A further complication is that a large chunk of subprime loans has been repackaged as assetbacked securities (ABS) and sold on to end investors. This securitized mortgage market in the US is massive at around US$6 trillion, of which about 14% is estimated to be subprime and a further 11% Alt-A. In some cases, early payment defaults mean that investors can 'put back' these securities to the originators, so the repackaging process does not always entirely shift the risk away from lenders. Overall, though, there looks to be potential for considerable distress within the ABS market, and in related markets such as those for collateralised debt obligations (CDOs) which concentrate mortgage default risk into highly leveraged equity tranches. Around US$200 billion of CDOs were issued in 2006.