The lenders will not go down without a fight but IMO the jeanie is out of the bottle. This is a recent question / answer forum with Paul McCulley at Pimco.
Q: Following PIMCO’s December Forum, you noted that the U.S. housing market continued to slow but that employment was holding up relatively well. Has anything changed in terms of the housing market or the potential for a housing spillover into employment and consumption?
McCulley: The new information we reviewed at the March Forum was the fact that the sub-prime mortgage market has been revealed to be a cesspool of irrational underwriting standards. We’ve long known this, but now the world knows, and lenders are tightening the underwriting terms for sub-prime borrowers as a result.
As Bill Powers noted at the Forum, there are three key factors in gauging troubled waters in the property market: long-term interest rates, the state of the job market, and the availability of credit. Right now, two of the three are very, very positive, while the third is turning very, very nasty.
What is the net effect? First-time homebuyers have driven the home ownership rate to record highs and fueled accelerating home price appreciation in the process. So I believe that reduced availability of credit for first-time homebuyers and other sub-prime borrowers will, in the fullness of time, dominate. But when will time be full? We don’t know.
What we do know is that job creation will be the key variable influencing the Fed’s rate decisions. We also know that no rational person can conclude anything other than that the popping of the property market bubble will ultimately have a negative impact on job creation, both directly and indirectly.
Q: Why is the tightening in mortgage lending standards such a dominant factor in the cyclical outlook if the tightening is confined to those with the weakest credit?
McCulley: From an investment perspective, the decisive question for the cyclical outlook is whether the recognition of risk in the sub-prime market will lead to a repricing of risk elsewhere. If you have one asset class that is infected with irrational exuberance, you could very well have others, so you have got to think in terms of the contagion effect from the investment side and then you have to think about what that means for the real economy. And from a macroeconomic perspective, the key question is whether the repricing of risk elsewhere, if it happens, will have a material effect on global aggregate demand, and therefore the real economy. From a monetary policy standpoint, the Fed and other central banks are not that worried about a repricing of mispriced risk, but they will become concerned if the repricing has a profound effect on the macroeconomic outlook. The Fed does not want to respond to a repricing of risk unless they have to due to contagion in the real economy.
Q: Why might the tightening of credit in the sub-prime market have a contagion effect?
McCulley: A tightening of underwriting terms is an intensely corrosive factor to leverage-fueled asset appreciation. Levered animal spirits are the stuff of boom, and when bankers tighten lending standards to levered speculators, liquidity becomes a mirage.
At the end of the day, liquidity isn’t about money stock growth, but a risk-seeking state of mind. In other words, liquidity isn’t about money on the sidelines per se, but rather about the risk appetite of those on the sidelines. And when risk appetite turns, no amount of liquidity on the sidelines matters, particularly when a crowd gathers there. This is the essence of modern day finance. The human condition is, in the end, momentum-driven, not value-driven.
