Will the Housing Slump Hurt Wall Street?

July 25, 2007 — -- Rising interest rates have cut home sales, which has led to a spike in mortgage defaults.

Private equity firms are borrowing like never before to finance deals, which results in less money to buy stocks and a decline in the Dow and other indexes, say analysts.

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."

Understanding the Economics

Low interest rates stimulate a housing boom by encouraging individuals to take out loans and purchase homes they otherwise might not be able to afford. But with fixed interest rates rising above 6 percent, people who took out adjustable rate mortgages are suffering and defaulting.

The low rates also encouraged aggressive borrowing by private equity firms that leveraged their debt in buyout deals.

These loans, coupled with aggressive leveraging of billions of dollars by hedge funds, are unsustainable, said Metz.

"The stresses in the system are virtually unprecedented," Metz said. "It's going to be with us for a long, long time."

The effects are being felt far beyond the housing market.

"There's no question that a deterioration in risky corporate bonds leads to a decline in equity," said Robert J. Barbera, chief economist at ITG brokerage firm, who disputes the six-month theory. "But you can't pretend to know the exact timetable. The junk bond market took a big hit in 1998 and never fully recovered. If you sold in 1998, you were a wee bit early."

Barbera says that corporate borrowing costs have risen spectacularly, tightening the market. "You're at a point where another leg up for interest rates would be very tough for stocks," he said.

The collapse of credit is definitely having an impact on the stock market, said Alan Ruskin, chief strategist at RBS Greenwich Capital. "In the general sense where credit terms tighten, i.e., effectively, the price of money is more expensive, that tends to slow the economy down, the capacity to finance all sorts of deals, not just in the financial world. It impinges on people's ability to get mortgages, [there's] less capacity to borrow at attractive interest rates -- that affects demand for everything."

Not everyone is expecting a market downturn, however. Alan Levenson, chief economist at T. Rowe Price, is more optimistic, saying that a decline in the housing market wouldn't seriously affect stocks.

"The feeling has generally been that the economy will muddle through the housing recession and not experience an overall recession," said Levenson, who noted that housing is only a small part of the U.S. economy. "What we see is that the housing market has not undermined overall employment or consumer employment."