Credit where credit is not due.

Expect that to be the market's rueful motto in 2003, when the latest tidal wave of lending inevitably starts going bad. Since the economy began slowing back in 2001, banks and other lenders have continued making loans at a breakneck pace, spurred on, of course, by the historically low interest rates set by the Federal Reserve under Alan Greenspan. That poor discipline will come back to haunt financial institutions this year, you can bet.

There have been two overlapping credit bubbles in the last five years. The first mania -- loans to New Economy companies like Enron and WorldCom -- has already gone bust, and lending to such entities has dropped off sharply. But the second fixation -- personal and mortgage loans to consumers -- is still powering forward. Indeed, it has become one of the main drivers behind economic growth, which is why a coming slowdown in consumer loan growth promises to be damaging.

Unsafe at Any Speed

For instance, mortgage loans to households grew 12% from a year ago in the third quarter, hitting $5.85 trillion. That pace of expansion is much faster than that seen at any time during the '90s boom, and marks the fastest growth in 12 years. As a result, the housing market is looking decidedly bubbly.

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The nation's median existing-home price jumped 9.8% in October from the year-ago period, compared with a 2% rise in inflation. October's increase was the biggest since 1987, according to the National Association of Realtors.

Meanwhile, mortgage delinquencies and foreclosures are at multiyear highs, and unemployment, the main cause of mortgage defaults, unexpectedly rose to 6% in November.

Despite this, financial institutions have continued to focus on borrowers with poor credit -- the so-called subprime market -- even though a number of lenders to this group of debtors have experienced serious problems due to bad loans. Auto and credit card subprime loans have so far been the most frequent source of trouble in the segment.

But look to subprime real estate loans as a trouble spot starting in 2003. A survey by industry journal National Mortgage News said lenders originated a record $60 billion in subprime mortgages during the third quarter. The survey projected more than $220 billion in subprime originations for the year, way in excess of 2001's $180 billion.

Household International ( HI), estimated to be the nation's largest subprime home lender, decided last month to sell itself to the U.K.'s HSBC ( HBC) at a price many thought ridiculously cheap. The reason for the low sale price could well have been that managers expected its mortgage book to sour badly.

Toil and Trouble

Hold on, many will say, why should this pace of lending be at all problematic when the economy is recovering? Well, when prices rise mainly because of a big infusion of credit, they are vulnerable to a steep drop when the credit spigot begins to get shut off, as it inevitably will. In other words, there has to be more than credit driving prices higher for a boom to be sustained.

But why can't the credit keep flowing, the bulls will ask? Take a look at the yield curve, which plots the yields on government debt of differing maturities. It is now steep, meaning rates on long-dated bonds are considerably higher than on short-dated notes, an arrangement that is very profitable for lenders.

That slope won't last long, however. Either the economy recovers and short rates move up, crimping banks' margins and pushing up mortgage rates; or long rates come down, which would mean the recovery has stalled, pushing defaults up.

Growing in the Dark
Mortgage Growth Increases During This Slowdown
Source: Federal Reserve, Detox

The Plastic Mountain
Consumer Debt Outstanding (billions, $)
Source: Federal Reserve, Detox

Either way, the housing boom has to stop soon, which will in turn act as a drag on the economy. Indeed, its contribution to economic growth is significant. Goldman Sachs economists estimate that borrowers -- using instruments like mortgage refinance loans -- withdrew $320 billion of equity from their homes on an annualized basis in the third quarter. They also estimate that very little of that amount is being used to pay down other types of debt. As a result, when the mortgage refi boom tapers off, the huge contribution it makes to spending will evaporate and the economy will feel it. What Greenspan and the bulls on Wall Street will never tell you is that an economy can't subsist on credit alone.

Cauldron and Fire

So which companies could feel the effect of worse credit numbers in 2003? Well, some already sickly ones could feel more pain, like credit card lender Capital One ( COF). It's highly unlikely that Sears' ( S) card portfolio will recover in 2003, given the large amount of subprime credit car loans it has made.

In the auto loan sector, AmeriCredit ( ACF), already a casualty of the subprime bust, will continue to sputter into 2003 as past-due loans rise. And due to hair-raisingly widespread use of heavily incentivized loans , the credit arms of Ford ( F) and General Motors ( GM) could experience bad loan problems in 2003.

When it comes to the housing sector, it's harder to pinpoint which lenders could get hit by a housing market downturn. Anyone doing subprime mortgages is at risk, however. Particularly exposed in this scenario is mortgage insurer MGIC Investment ( MTG), which has already had problems with delinquencies this year.

Among mainstream banks, Citigroup ( C) and Washington Mutual ( WM) make subprime mortgages. It would take quite a downturn to hurt borrowers with good credit -- and very few economists are expecting a recession in 2003.

But the growth in the prime-borrower sector has been so strong that a handful of lenders could get hurt even without a grinding slowdown in the economy. Especially vulnerable could be those focusing on markets where house prices are inflated, like the Northeast and some areas in California. Indeed, Wells Fargo ( WFC), adored on Wall Street, has considerable exposure to heady Western house prices and has a fair-sized subprime mortgage book, too.

Finally, what's the outlook for Fannie Mae ( FNM) and Freddie Mac ( FRE), the two government-coddled institutions that buy billions of dollars worth of home loans every year and provide enormous support to home prices? Freddie's comparative conservatism should mean it will have an uneventful 2003. However, margins at Fannie, the bigger of the two, could be crimped by recent aggressive hedging policies that had to be entered into because the lender was too exposed to a drop in interest rates. Signs that Fannie is running an overly risky book could depress its stock price and invite scrutiny on Capitol Hill. If that happens, expect it to slow the breakneck speed at which it has been expanding its loan book.

The credit crunch is far from over.
In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to

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