Deteriorating economic conditions affects the tightening of credit terms far more than a turbulent financial market, said Jeffrey Lacker, president of the Richmond Federal Reserve Bank, in a speech Monday. “The conventional wisdom is that the credit market disruptions we’ve seen over the last year or so impede the financial sector’s ability and willingness to extend credit to households and business firms, thereby creating an additional drag on spending,” he said. But household income typically deteriorates just as economic activity is poised to contract, implying that individual households and businesses will become less creditworthy, making it “hard to disentangle the effect of lenders’ increased cost of capital from the deterioration in the economic environment facing their borrowers.” Lacker said players in the market need to “give serious consideration to the idea that this episode of credit and financial market turmoil is part of the economy’s natural response to the sharp decline in the underlying fundamentals in housing finance.” The downturn in economic growth is usually cited as having been caused, at least in part, by subprime lending’s role in the housing boom, and the effects it continues to have as borrowers default on subprime loans and risk going into foreclosure. People can argue for years about factors that may have contributed to a growth in subprime lending, Lacker said, but a “list of plausible suspects is clear.” A look at the plausible suspects “Subprime lending with high loan-to-value ratios was profitable while home prices were rapidly rising, but profitability fell sharply when price trends reversed,” leaving lenders to absorb some unanticipated losses, Lacker said. Many of these losses are incurred due to the volume of bad loans — primarily subprime and nontraditional — pushed through during the height of the housing boom. “Official policies aimed at increasing homeownership also provided at least some positive inducement to risk-taking in housing finance,” he said. “In addition, the unscrupulous and fraudulent practices of some mortgage brokers outside of the banking sector may have contributed to the problem.” Home price indexes are falling dramatically in some markets, causing erosion of equity, Lacker said. The decline in housing activity since 2006 has affected both credit markets and broad economic activity. It has reduced consumer spending and diminished net home worth. High energy costs have also cut into real income. Labor markets have weakened, causing wage growth to level out somewhat. A recent slump in oil prices hasn’t reversed a spending trend toward vehicles with relatively low fuel consumption. Rather, Lacker said, the fluctuating oil prices “may be making buyers quite cautious about choosing among automotive technologies right now.” Lacker acknowledged some corrective action has already been taken to ease the credit crunch. Banks and investors have curbed their appetites for nontraditional and subprime mortgages and for the services of independent mortgage brokers. Banks and mortgage originators have also tightened mortgage underwriting standards, a move Lacker said reflects “both revised assessments of the profitability of more innovative lending approaches and a generally weakening economic outlook.” The subprime boom may have ended, but industry players have been increasingly uncertain about the total amount of losses on mortgage lending, Lacker said. Specifically, they’re unsure where these losses will eventually turn up due to the fragmentation of mortgage risk through securitization. An optimistic outlook Household consumption goes along with income prospects, Lacker said, so an improvement in consumer spending growth depends on a shift to a more optimistic assessment of household income. “Once households are convinced that an end to the deterioration in labor market conditions and the fall in equity and home prices is in view, however, consumer spending growth will be based on improving longer-run income prospects and is likely to pickup substantially,” he said. Analysts looking ahead to coming years expect the U.S. economy to regain positive momentum sometime in 2009, according to Lacker, who did not name specific analysts backing such a sentiment. He did say he agreed with the idea of near-term recovery on several levels: Monetary policy has become “quite stimulative” due to the recent lowering of the federal funds rate, and major shocks that contributed to the downturn in economic activity “have already subsided or are in the process of doing so.” Lacker tempered his comment that he’d be “surprised” if housing construction doesn’t bottom in mid-2009 with a bit of a disclaimer: “This is the third straight year, however, that I’ve been expecting a bottom in the housing market in the middle of next year, so my outlook is tempered by more than the usual amount of humility.” Overall, Lacker said the picture for 2009 should be one of an economy beginning to recover due to changes in monetary policy. This optimistic view seems to disagree with the large banking entities that have separately said the credit crunch will continue through 2009. JP Morgan Chase & Co. (JPM) CEO Jaime Dimon, for example, on Monday said the company faces “highly challenging conditions” in 2009, leaving the forward-looking view of next year somewhat cloudy. Write to Diana Golobay at diana.golobay@housingwire.com. Disclosure: The author held no relevant investment positions when this story was published. Indirect holdings may exist via mutual fund investments. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.