Throughout 2007, we have heard increasing concern about the financial crisis in the sub-prime mortgage market. Lenders took huge risks over the past few years. First, they believed there was no end to the fortune that could be made in the white-hot housing market. Second, new loan packages allowed the risk of these loans to be spread over a much larger group of investors. In response, lenders extended credit to households that once would have been turned away and loaned funds for a larger share of a home's value (up to 100 percent and more).

Distress felt across the board

The downturn in the housing market, however, has created a surge in delinquencies, defaults, and foreclosures that have come back to haunt the industry, causing financial distress and even bankruptcy. Nor has this distress been confined to sub-prime lenders: it has spread to the much wider financial community as well. Even Countrywide Financial Corp., the nation's largest mortgage lender, reported a 33 percent drop in second quarter net income.

Similarly, Wall Street firms, who now hold large shares of mortgage securities, were shaken by the deteriorating quality of these investments. Among them, Bear Stearns disclosed that two of its hedge funds were virtually worthless because of sub-prime mortgage losses. Even overseas financial markets reeled from the effects of the U.S. crisis, given the large number of foreigners heavily invested in U.S. assets.

In August, the Fed quickly moved to quell fears of a worldwide financial crisis by dropping the discount rate, making billions of dollars available to member banks, and promising to act to mitigate any further adverse effects on the economy. Just how severe the credit crunch will be, however, is as yet unclear. The impact on the cabinet and furniture industries will undoubtedly be negative, but how negative will depend on an individual firm's end markets as well as its own personal liquidity.

Feeling the pinch

The impact will be most piercing for those whose sole end market is single-family housing. The current financial crisis will visibly deepen and lengthen the decline in housing. As credit conditions have tightened, even prime borrowers and those needing "jumbo loans" (above $417,000) have felt the pinch, causing overall homebuyer demand to slow. At the same time, the increasing number of homes that have gone into bankruptcy is adding to already abundant supply. Unfortunately, this mismatch is expected to continue well into 2008.

Fixing the problem

Recent federal banking guidelines are also likely to extend the current downturn even while they aim to curb the underlying problem. The guidelines require lenders to underwrite loans based on a borrower's ability to make payments on a loan's adjusted rate, not just the low introductory rate. Lenders are also expected to collect more information to prove that borrowers have the ability to make the monthly payments. These requirements, aimed at preventing future problems, are nevertheless likely to further reduce homebuyer demand in the months ahead.

Those whose end market lies in commercial development (office, retail, hotel, multifamily, etc.) will also be negatively affected, although to a lesser degree than single-family housing. The impact on commercial construction is likely to be more pronounced in 2008, rather than this year. Credit conditions for commercial properties began to tighten even before the current financial market turmoil. But because these loans need to be secured well in advance of construction, this shift in lending posture is not likely to have a discernable effect on construction until next year.

Although the Federal Reserve's actions appear to have calmed the panic in financial markets, their longer-term success will be needed to restore the liquidity that will boost end market demand. The next few months will be critical in determining whether the economy comes to a soft landing or slips closer to recession.