Will the Housing Slump Hurt Wall Street?

July 25, 2007 — --

That's a gloomy scenario at a time when the Dow rose above 14,000 for the first time last week, and the S&P 500 hit an all-time high. But volatility is also rising, with the Dow dropping 226 points Tuesday as investors worried about rising loan defaults.

Can the good times last with a credit crunch in full swing? As borrowing gets more expensive, lenders demand better terms or even refuse to extend credit for riskier ventures. Some analysts we spoke to expect investor jitters to continue with a stock selloff in the next few weeks. Others hesitated to predict.

If a downturn happens, it's been a long time coming. And the really big key is interest rates. When lenders raise rates, as seen in the recent housing slowdown and downturn in the bond market, the consequences soon reverberate on Wall Street.

One popular theory, advanced by economic strategists at Morgan Stanley, is that equity markets tend to collapse six months after credit markets do. Since credit, including housing loans, began to weaken last February, look for the market to take a hit next month, according to this argument.

Michael Metz, the chief investment strategist for Oppenheimer & Co., said that we are beginning to see the consequences of a series of overeager and unprincipled decisions made earlier in the decade. He pins part of the blame on former Federal Reserve Chairman Alan Greenspan's aggressive monetary policy after the 9/11 attacks, when interest rates were pushed down as low as 1 percent.

"You're getting the hangover of an extraordinarily stimulative monetary economy inspired by Greenspan when money was basically free," Metz said. "I don't see any reason for [the market] to go up at this juncture."