The Fed Takes Subprime Woes in Stride

As subprime mortgage troubles aren't sapping the larger economy, the Fed won't drop interest rates, likely holding them at current levels for now

by Peter Coy

Rising interest rates threaten to force loads of homeowners with subprime mortgages into foreclosure. The Federal Reserve could have relieved the pressure on those homeowners by lowering rates on June 28. But it didn't, leaving the federal funds rate at 5.25%, right where it's been since last summer.

Hard-hearted and cruel? You could argue that. But the way that Federal Reserve Chairman Ben Bernanke and his fellow members of the Federal Open Market Committee see things, they can't afford to mess up the rest of the U.S. economy to rescue the relatively small ranks of subprime borrowers.

Putting the Majority First

By cutting short-term rates now, the Fed runs the risk of causing the financial markets to get frothy and the real economy to overheat. When the economy grows too quickly, demand exceeds supply and inflation sets in. That's intolerable to the Fed, whose main job is to keep the economy growing at a healthy pace with minimal inflation.

Put it this way: The U.S. has a population of a little over 300 million. By comparison, there are a little under 10 million outstanding subprime loans, of which a little over 20% are delinquent or foreclosed on. Assuming typical household sizes, that's around 5.4 million people affected, calculates analyst Michael Youngblood of FBR Investment Management. By leaving interest rates where they are, the Fed is implicitly putting the interests of the majority ahead of the interests of the minority.

Ironically, the best hope for subprime borrowers would be for the troubles in the subprime world to spread to the rest of the economy. A problem that became widespread and systemic would most likely jolt the Fed into cutting rates, helping relieve the pressure on subprime borrowers as well as on the rest of the economy.

Economic Rebound Seen

So far, though, there has been relatively little contagion from the subprime mess. True, the inability of people with poor credit to qualify for home loans is one factor in the recession that's shaking the homebuilders. Lennar (LEN), one of the biggest builders, on June 26 reported a $244 million loss in its May quarter (see BusinessWeek.com, 6/26/07, "Housing Woes Hammer Lennar"). KB Home (KBH) checked in June 28 with an equally dismal report, reporting a loss when Wall Street had been expecting profits. It's also getting a bit harder for companies to buy each other with huge amounts of borrowed money—although it's not clear whether that's a good or a bad thing.

On the whole, though, the U.S. economy seems to be rebounding from a weak first quarter, when growth was below a 1% annual rate. Action Economics is looking for gross domestic product in the June quarter, which is just ending, to rebound to a healthy 3.5% annual rate.

In fact, the economy is looking so healthy that long-term interest rates have risen nearly half a percent since early May. Investors are increasingly persuaded that the Fed will not need to cut rates to stimulate growth, as they once believed it would have to. "The U.S. economy is still being flooded with liquidity from abroad, money is easy, and spreads [which indicate fears of default] are narrow," analysts Jason Rotenberg and Noah Yechiely of Bridgewater Associates wrote on June 26.

Taking the Hit

Are people cutting back on borrowing—a classic sign of a credit crunch? Companies certainly aren't. Rotenberg and Yechiely note that corporate borrowing "has reached levels not seen since the late 1990s."

Numbers that look frightening on the individual level seem less significant in the context of a U.S. economy that generates $10 trillion in personal income annually, which is what the Fed keeps its eye on. In a June 27 note, economist Edward Yardeni of Yardeni Research said that even if you buy Bank of America's (BAC) forecast that $500 billion worth of adjustable-rate mortgages are scheduled to reset this year by an average of 2 percentage points, that comes to only an extra $10 billion to $15 billion in interest payments. That's a tenth or so of 1% of total personal income. Yardeni's reaction was to quote the title of a classic Peggy Lee song: "Is that all there is?"

Coy is BusinessWeek's Economics Editor.