Starting from the late 90’s, American households have been spending more than their disposable personal income on consumption or interest payments on account of low interest rates, foreign investments in a booming market and rising housing prices (approx 124% between 1997 and 2006) which added to their confidence in the economic indicators.
The sub-prime lending added on to the increase in home ownership rates and demand for housing by giving easy access to low profile borrowers to invest in a booming real estate market and thereby resulting in home ownership rate increasing from 64% in 1994 (it has been at a similar rate since 1980) to 69.2% in 2004 as per the reports by US Census Bureau on residential vacancies and homeownership.
The spurt in housing resulted in homeowners resorting to refinancing of homes at lower interest rates, or taking second mortgages on homes to enhance their spending and other needs and ended up in household debt as a percentage of annual disposable personal income @ 134% by the end of 2008 against 77% in 1990 at a staggering $14.5 trillion.
Though these mortgages attracted borrowers with a sub-prime rate for some fixed period initially, when borrowers were unable make the higher payments once the initial grace period ended, they tried to refinance their mortgages. Once house prices started to crash (by over 20% from their peak in 2006), refinancing became more and more difficult and borrowers burdened by high monthly payments began to default. Borrowers can resort to just walk away from their mortgages and abandon their homes in-spite of the consequence of damaging credit rating. Moreover, US residential mortgages are non-recourse loans i.e. if creditor repossesses the property purchased with a mortgage in default he has no further claim against defaulting borrower’s income/assets. With more defaults and foreclosures, supply of homes for sale rises moving prices downward, and along with it the homeowners’ equity. This also reduces the value of mortgage-backed securities, which erodes the capital of banks dealing with such securities. This has formed a vicious cycle which is at the heart of the crisis.
Please enrol me for the free email course
on Basics of Accounting for Financial Instruments
Join our mailing list to receive the latest news and updates from our team.