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The U.S. housing sector crisis financial scene

What ails the U.S. housing sector? What are sub-prime loans and securities issued out of pools of mortgage debt? What is the relevance of all this to India? Answers to these and many other related questions hinge on an understanding of the problems of the U.S. housing sector.

A simple, lucid elucidation of the current state of the U.S. home loan market is found in a speech by Martin Feldstein, President of the National Bureau of Economic Research . (Speech delivered at the Kansas Fed’s Jackson Hole Seminar and reproduced in The Wall Street Journal online edition dated September 2.) In the accompanying article, R. Viswanathan, a senior banker, explains the contextual significance of the sub-prime crisis in India.

According to Mr. Feldstein, the housing sector is at the root of three distinct but related problems. First, the sharp decline in house prices and the related fall in home building could lead to a general recession. Second, the sub-prime mortgage problem has caused a substantial widening of credit spreads and a freezing of much of the credit markets. Third, a decline in home equity loans and mortgage refinancing (tools for unlocking the value of homes) could cause spark a decline in consumer spending.

Until 2000, house prices and rents in the U.S.moved together. Thereafter, house prices surged ahead of rentals. Easy availability of credit and tax breaks were the principal reasons. Mortgage money became plentiful. Securitisation diversified the risks away from the original lenders. Lending standards might have become lax. Buying a home became an ‘irresistible’ investment opportunity for most Americans.

At some point home owners realised that property prices could not go on rising. Falling prices led to a sales rush against a slowdown in buying. resulting in a high inventory of unsold homes. Home builders postponed their construction plans.

In the U.S. declines in housing construction have often been the precursors to a general recession. A substantial portion of household wealth in that country is tied to the value of homes. A decline in home prices would seriously dent consumer spending and push the economy into a recession. No less significant is the impact of sub - prime mortgages on credit availability. In fact what should normally have been considered risky loans were actively promoted by mortgage brokers, banks and others under the mistaken notion that financial markets, the world over, had somehow become safer. Securitisation and credit derivatives dispersed the risks. There was also the feeling that the U.S. Federal Reserve would ease monetary policy in the event of a crisis. Rating agencies have played a less-than-stellar role. Investors bought some of these ‘pooled’ assets without understanding the true risks. As Mr. Feldstein says, “This was clearly an accident waiting to happen. The sub-prime problem unfolded quickly with very high default rates on sub-prime loans.”

Loans to many categories of borrowers became costlier. “It will of course be a good thing to have credit spreads that correctly reflect the actual risks of different assets. But the process of transition may be very costly to the overall economy.”

The problems in the housing sector also adversely affect the economic outlook in another way. Consumer spending is likely to drop substantially in response to declining home equity withdrawals through home equity loans and mortgage withdrawals. In the U.S. it is possible for most borrowers to repay a home loan (mortgage) without penalty when interest rates fall. They can replace the costly loan with a new one at cheaper rates. If the value of the property increases, refinancing can generate additional cash for the home loan borrower, the so called mortgage equity withdrawal.

During a period of easy and inexpensive credit accompanied by rising property prices, refinancing was actively encouraged. Borrowers not only saved on interest cost but had a surplus which they, partly at least, spent on consumption.

In 2005, 40 per cent of existing mortgages were refinanced. Mortgage equity withdrawals between 1996 and 2006 aggregated more than $9 trillion, an amount equal to more than 90 per cent of disposable personal income in 2006.

C. R. L. NARASIMHAN

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