Will the US sub-prime mortgage meltdown spread?

If the US housing market has turned a corner, then no one told HSBC. The bank announced that bad debts would be 20% higher than expected this year - and the US sub-prime market is to blame.

US housing market has turned a corner, then no one told banking giant HSBC (HSBC).

The group warned on profits last week, reporting that bad debt provisions would be 20% higher than expected in 2007, with the overall damage coming in at $10.6bn.

What was the problem? Simply put, more customers at its US mortgage unit Household, which writes mortgages for sub-prime customers (ie those who can't get credit anywhere else), have stopped paying their bills than it expected.

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And it's far from being the only one having problems

It's not just HSBC that has been taken by surprise by the worsening state of the US housing market. Already 18 sub-prime lenders have gone to the wall. And last week, one of the biggest, New Century Financial, said it expects loan production to be down 20% on 2006. It will post a fourth-quarter loss, and is to restate earnings for the first three quarters. The group is also 'tightening underwriting guidelines and taking other steps to further improve fraud detection and risk management'.

Meanwhile, on Friday Countrywide, the top US mortgage lender, said foreclosures (repossessions) were the highest since 2002, with late payment at a near five-year high, even though it has been tightening its own lending criteria.

This tightening is a theme, says Ambrose Evans-Pritchard in The Telegraph: 'Wells Fargo has stopped providing 100% mortgages in California, demanding 5% down.' And the latest Federal Reserve survey of senior loan officers found that more banks are tightening lending standards 'than in any quarter since the early 1990s', according to Bloomberg.

Banks tightening lending criteria is generally a bad sign. In fact, one Michael Metz of Oppenheimer & Co. told Marketwatch that announcements like this are a "natural event to trigger a correction or at least an extended consolidation in the market.'

And yet, the US stock market continues blithely onward as though nothing much is happening. The Dow Jones Industrial Average ended last week down 0.6%% at 12,580 - hardly a correction.

Metz blamed the lack of more serious falls on 'entrenched bullishness', and warned that there's likely to be more to come from the sub-prime sector and junk bond market in general. Given that sub-prime loans made up 20% of all new housing loans in the past two years, according to Professor Nouriel Roubini of New York University, he may well be right.

He's certainly right about the "entrenched bullishness". The scene of investors piling into Fortress as it became the first hedge fund and private equity group to list in the US was a case in point. The shares rose 68% from their placing value of $18.50 a piece, suggesting that investors no longer care what they pay - if they see a hot asset class, they'll just pile in.

And over in London, the potential bid by private equity for supermarket group Sainsburys (SBRY) has caused more than a few commentators to suggest we're at the top of the market - the Evening Standard's Anthony Hilton likens it to the ill-fated private equity takeover of former supermarket player Gateway in 1988.

As Hilton puts it: 'The bidders got into an auction, where egos came to the fore - proving that some things never change - and the winners overpaid. Then interest rates doubled, the economy crashed, and they lost everything. In passing, they also destroyed the business.'

These are all symptoms of the cheap money fuelled irrational exuberance clutching asset markets everywhere. But now, in at least one sector, the cheap money is drying up. And that could have a knock-on effect.

There's plenty more data due on the US housing market this week - if there's any surprise to the upside, expect to see plenty more irrational exuberance. But make no mistake, this is the thin end of the wedge - we haven't seen the worst of the sub-prime fall-out yet.

My colleague Cris Sholto Heaton wrote about the wider dangers of these loans at the end of last year - to see how the sub-prime meltdown could have wider implications for other markets, see: US housing market is different this time - it's worse

Turning to the stock markets

In London, the FTSE 100 hit a new six-year high on Friday, climbing 36 points to end the week at 6,382, as the average was boosted by strength in the banking sector.

On the Continent, the CAC-40 ended the day at 5,692, a 37-point gain, whilst the Frankfurt DAX-30 closed 34 points higher, at 6,911.

Across the Atlantic, stocks closed lower as the price of crude continued to rise. The Dow Jones industrial index was down 56 points, at 12,580. The tech-heavy Nasdaq lost 28 points to close at 2,459. And the S&P 500 ended the week 10 points weaker, at 1,438.

In Asia, the Hang Seng fell 84 points to close at 20,593 as China Mobile weighed. The Nikkei was closed for a holiday today.

Crude oil had fallen nearly 1% to $59.36 this morning. In London, Brent spot was at $57.48.

Spot gold hit its highest level since mid-July - $668.20 - in Asia trading but had slipped back to $665.75 this morning. Silver, meanwhile, was unchanged at $13.84.

And in London this morning, Vodafone shares were up by as much as 1.8% following news that the mobile telecoms company had been successful in its bid for Indian firm Hutchinson Essar.

And our two recommended articles for today...

Why investors should be wary of Sainsbury bid

- In the light of the 'irrational exuberance' which greeted last week's rumours of a private equity bid for J Sainsbury, Jeremy Batstone warns investors to never forget the risks involved in such deals. For more on why the rumours should set investor alarm bells ringing, see: Why investors should be wary of Sainsbury bid

Prepare for a flight to gold

- Gold's recent return above the $650 level is a key development in the metal's bull market. To find out just how high gold could go this year - and the one small cloud hovering on the horizon - read: Prepare for a flight to gold

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.