Download US housing crisis special features not generally present in Europe

Economic Research Department
No. 119 – November 25, 2008
US housing crisis special features not generally present in Europe
 Traditionally, the credit cycle downturn and
housing correction occur in the wake of interest
rate increase triggered by central banks to calm
down an overheating in economy. The weakening
economic conditions and more importantly the
accompanying rise in unemployment are factors
that prompt credit defaults which in return
heighten the cyclical adjustment on the lending
side and on housing market.
 The US housing correction is partly running
counter to this logical sequence as the direction of
the causality this time ran mainly from the housing
market, and the sharp increase in subprime
mortgage defaults, to the rest of the economy.
 The collapse of the high-risk subprime sector
added a new toxic twist to the downturn in the US
housing market.
 However, housing booms or bubbles have
arisen all over the world and their correction will
be painful. In Europe, the economic adjustments
will be more traditional in style, in step with the
economic slowdown and the severity of the impact
will vary among countries in line with the excesses
seen during the upswing.
Today it is tempting to draw a parallel between the
severe housing correction that got underway in the
United States at the end of 2005 and the more recent
housing downturn in Europe. Although the property
bubble has taken on a global cast, with price increases
well in excess of those justified by the fundamentals
alone, it would be a mistake to predict that the
downturn will be as brutal in Europe as in the United
States. The severity of the US correction is due to a
number of factors specific to the US market which
were not present in the European context.
United States: a singular housing correction
For starters, it is interesting to note that in the United
States the rise in subprime mortgage defaults began
long before there was any sign of economic slowdown
or, more precisely, in the absence of any visible
downturn in the labour market. Traditionally, the
credit cycle downturn and housing correction occur
in the wake of interest rate increase triggered by
central banks to calm down an overheating in
economy. The weakening economic conditions and
more importantly the accompanying rise in
unemployment are factors that prompt credit
defaults which in return heighten the cyclical
adjustment on the lending side and on housing
market.
Any income shock (often linked to the occurrence of a
period of unemployment, divorce or medical
emergency) is reflected in a sudden squeeze on
household budgets. Those that find themselves unable
to honour their financial commitments may be obliged
to sell off their assets in a hurry, often at a substantial
discount.
Speculation also acts as an amplifier. During the
cyclical upswing, some homebuyer investors (as
opposed to owner-occupiers) take increasingly risky
leveraged positions in the hope of realising a rapid
capital gain when they re-sell a housing asset. Their
financial balances are subject to severe pressures in a
falling housing market. This all fuels fire sale prices and
the rise in the default rate, notably when the proceeds
from the sale fall short of the amount needed to retire
the debt. Bank balance sheets are jeopardised and
credit becomes less available.
The US housing correction is running counter to this
logical sequence as the direction of the causality this
time ran from the housing market, and the sharp
increase in subprime mortgage defaults, to the rest of
the economy. Mortgage default rates began to rise as
of mid-2005, with a surge in early 2006, whereas the
unemployment rate only really began to rise from mid2007. Underlying this early downturn was the total
collapse of a particularly fragile market segment,
namely the notorious subprime mortgage.
% (sa)
US: delinquency rates on subprime loans
24
23
22
21
20
19
18
17
16
15
14
13
12
11
10
9
8
7
1998
2000
Source : MBA, CA.
fixed interest rates
adjustable interest rates
2002
2004
24
23
22
21
20
19
18
17
16
15
14
13
12
11
10
9
8
7
2006
2008
grey areas: US recessions
It is worthwhile taking another look at the overall
conditions that fostered the emergence of this highrisk market segment.
Internet: http://www.credit-agricole.com - Economic Research
Isabelle JOB
[email protected]
Post dotcom bubble1 global monetary activism and
the global saving glut resulted in massive liquidity
flows into the financial sphere, which were
responsible for the abnormally low short- and longterm interest rates (the celebrated conundrum). In
return, access to cheap funding allowed many
people to take on debt, which fuelled housing
demand and spiralling house prices. As prices rose,
lending supply and demand both gradually became
growing factors pushing home prices higher. Rising
values for the underlying loan collateral and falling
perceptions of risk led to an excessive easing of
lending conditions. This enabled financially fragile
households to become home-owners in line with
public policy goals which promoted the idea of
home ownership for all.
Financial innovation and the development of the
"originate-structure–distribute" model fed the
growing imbalance. A banker or financier originates
the loan and then sells it in the marketplace. In
theory, loan securitisation is supposed to improve
the efficiency of the financial system as a whole by
spreading the risk more widely. In practice, the
decoupling between the originator of the loan and
the end-carrier of the risk lowers the incentive to
assess and monitor risk.
Driven by these various factors, a large volume of
risky, and hence fragile, credits arose. . This is
especially true in the United States, where the
subprime market at its height weighed in at nearly
USD 1.4 trillion, but it was also the case more
generally in Anglo-Saxon countries, where the loan
is made based on the value of the asset rather than
on the borrower's income.
The US property bubble was therefore above all a
credit bubble, even if more traditional bubble
mechanisms occurred in some regional markets,
such as purely speculative purchases for rapid
resale, marked risk-taking by promoters and real
estate agents, and excess supply of new housing illsuited to demand.
United States: collapse of an entire loan
sector
According to a study by the Bank of International
Settlements2 (BIS), in the United States, the
widespread approval of risky loans was on a par
with the competition between increasing numbers of
loan originators, in order to gain market share. The
originators' imaginations were working overtime to
increase the supply of credit to lend to an
increasingly risky customer base, especially given
that the loan originators could pass on the risk via
securitisation.
1
The Fed Funds rate stayed below 2% between early 2002 and
and 2004, with a low point of 1% in 2003, while the ECB's refi
rate remained at 2% from mid-2003 to December 2005.
2
Lucy Ellis : The housing meltdown: Why did it happen in the
United States. BIS Working papers No. 259, September 2008.
No. 119 – November 25, 2008
In the first place, non-documented loans (ie, loans
where no credit checks were carried out to verify
the information supplied by the borrower) became
legion. In 2001, around 30% of securitised subprime
mortgages were relatively undocumented, with the
proportion exceeding 50% for the 2006 vintage2.
The same year, less than half of all ALT-A loans,
despite being thought more risky than traditional
mortgages, were granted on the basis of full
documentation. This absence of background checks
on borrower creditworthiness is not specific to the
United States since the same trend was observed in
the United Kingdom and Australia, although it was
less pronounced in the latter where 10% of new
loans originated in 2005 had a level of
documentation deemed to be weak.
Secondly, in a low interest rate environment, the
supply of Adjustable Mortgage Rate loans, or ARMs
spread considerably. Some products were made
even more attractive with the introduction of a socalled "teaser" rate, a rate often below market levels,
and designed to entice borrowers to buy more
expensive homes by lowering the initial monthly
mortgage payments. This form of "promotional"
supply was sold particularly aggressively in the
United States, since the teaser rates could be set
anywhere from 3 to 4 percentage points below the
going market rate. In comparison, the difference
between the standard rate and the teaser rates never
exceeded 1% in the United Kingdom or Australia.
The easing of loan standards also took other forms,
notably with the development of "piggyback"
mortgages, the growing recourse to home equity
loans or revolving mortgage mechanisms3. In the
first case, in order to circumvent the 20% personal
down-payment rule which is supposed to protect the
creditor4, lending organisations proposed offers
where by combining a primary and a secondary
mortgage, borrowers could cover the total cost of
the purchase without having to take out private
mortgage insurance (which is normally mandatory
when the personal down-payment is less than 20%).
In the second case, households were able to benefit
from the value of the home by taking out additional
loans. The period also saw the rise of Interest-only
mortgages, where the principal was repaid in fine
(at maturity), or option adjustable rate mortgages
that allowed negative amortisation, where the
share of interest still owing was added to the
balance of the principal with a view to subsequent
3
This mechanism may take several forms:
-additional drawdown on a loan that was initially a mortgage
(equity release, in the strict sense of the term).
- refinancing a mortgage with the same lender, but with an
increased amount in line with the increase in the value of the
mortgaged asset.
- independent mortgages, where the new lender only benefits
from a second rank mortgage.
4
Generally a personal down-payment of 20% is seen as a
minimum to ensure that the collateral can cover the amount of
the loan in the event of a market downturn.
2
Isabelle JOB
[email protected]
repayment. In the first quarter of 2007, over 40% of
new mortgages originated before restructuring
belonged to one or other of these classes.
With this aggressive credit enhancement policy,
loan to value ratios spiralled, and 100% financing
became more frequent. As a result, the likelihood
grew that increasing numbers of households would
find themselves in "negative equity" situations,
where the amount of the loan is higher than the
value of the asset) in the event of a market
downturn. Thus, 18% of mortgages originated in
2006 exceeded the value of the collateral by the end
of 20062. This should be compared with Bank of
England estimates, which say that fewer than 5% of
UK households are likely to find themselves in a
position of negative equity in the event of a fall in
house prices of more than 20%.
yoy %
24
USA :Housing prices
yoy %
24
20
16
20
16
12
8
12
8
4
0
4
0
-4
-8
-4
-8
-12
-16
-12
-16
-20
-20
1976
1981
1986
1991
1996
2001
2006
OFHEO
median existing home price
S&P Case-Shiller (10)
Recession in grey
Source : NAR, OFHEO, Global Insight, CA.
Stalling house price gains and the higher cost of
credit in the wake of the rising interest rates that
began in mid-2004 led to big problems for many
recent homebuyers as their financial solvency was
sustainable only in an environment of low interest
rates and rising home values). One final factor
specific to the US situation accelerated the default
spiral. Mortgage loans in many states are said to be
non-recourse, insofar as only the mortgaged asset
can be repossessed if the borrower defaults. In the
case where the mortgage taken out exceeds the
value of the real property and the value of the asset
is unlikey to return to the value of the mortgage
owed (negative equity) the incentive to default may
become compelling.. When one realises that in
some regions, property prices fell by 30% in the
space of a year, one can understand why default
rates rocketed.
It is therefore not overstating to speak of the
"subprime crisis" when referring to the
unprecedented financial turmoil we are currently
experiencing. The triggering event really did stem
from the collapse of one segment of the market,
which raised awareness not only of the excessive
accumulation of a heavy global liability but also,
and more importantly, of the sharp deterioration in
the quality of that debt.
No. 119 – November 25, 2008
United States/eurozone: wrong to compare
The fact that one can highlight specific factors that
explain the severity of the downturn in the US
housing market does not mean that European
housing markets are safe from a correction. The
housing cycle has matured in Europe too and the
markets will have to adjust in line with the
slowdown in activity. Here though, it is a more
traditional-style adjustment, corresponding to a
logic that emerges when the slowing economy
interacts with finance via the cyclical rise in the
default rate.
After a decade of marked price increases and strong
sales in most European countries, a correction is not
surprising. The scale of the adjustments will be on a
par with the excesses seen during the cyclical
upswing. In countries like Spain and Ireland, for
example, the corrections could prove quite painful.
Outside of Spain and Ireland, the over-valuation of
prices remained limited and housing construction
did not surge excessively, in our view. In the other
eurozone countries, and notably in France and Italy,
the adjustment has been gradual, until early 2008,
when it picked up due to the worsening financial
crisis and the deteriorating economic situation.
320
Housing Price Indices
Index base 100=1990Q1
280
240
200
160
120
80
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
UK
Spain
France
Source s : Halifax, Ministerio de Fomento,Fnaim, NAR
US
Overall, however, eurozone banks pursued very
cautious lending policies. The lending decision
focuses on the borrower's financial solvency,
which in most cases made it possible to rein in the
surge in lending by decoupling it from rising house
prices. The banks remained attentive to borrowers'
creditworthiness and their ability to cover their
mortgage repayments, and did not develop a
subprime segment.
The boom in lending was nevertheless sustained
more or less everywhere, with the notable exception
of Germany, due to access to cheap funding. The
countries that were lagging behind in terms of
lending saw the most spectacular increases as they
caught up with the field. At the top of the cycle,
solvency ratios, although they had deteriorated, did
not seem unsustainable in spite of the fact that one
might reckon that they had reached their limit. The
household debt burden, for example, amounts to 7080% of GDP for the most heavily indebted countries
3
Isabelle JOB
[email protected]
such as Ireland or Spain, while the eurozone
average is around 50-60% (ie, in France, Germany
and Belgium). Household debt, calculated as a
percentage of disposable income runs about 80% in
the eurozone, compared with 100% in the United
States and 130% in the United Kingdom.
Households' Mortgage debt
%
(mortgage debt/disposable income)
150
120
90
60
30
0
2002
2003
Germany
2004
Spain
2005
France
UK
2006
2007
USA
sources : Central Banks
Europe's banks have also been less sensitive to
financial innovation. Only Spain used the
securitisation lever to the full and simultaneously
relaxed its lending standards, with the generalisation
of variable rate mortgages and excessive lengthening
of maturities in order to fuel its lending machine.
The supply of loans remained fairly traditional in
structure, with historic features, specific to each
individual country (fixed rates, average maturities of
15-20 years and fully amortizing loans for France;
variable rates and generally longer maturities in
Spain and Italy. Last, the regulatory framework for
personal bankruptcies remains more restrictive in
Europe and is subject to a lengthy verification
process. In most countries, the banks can call in the
mortgage if the borrower defaults. In such cases, the
outstanding debt is prorated on the proceeds of the
resale, with creditors retaining their rights on the
other assets to cover any negative balance. The
incentive to default thus seems limited and
payment defaults mainly occur in cases of
unemployment or other ups and downs.
House price declines could be on a scale similar to
or even greater than in the United States without
triggering such a severe spiral of defaults with
knock-on effects on finance. In fact, the
distinguishing factor that will govern the rise in the
cost of risk in bank balance sheets will depend
more on the scale and length of the looming
recession… „
Crédit Agricole S.A. — Economic Research Department
75710 PARIS Cedex 15 — Fax: +33 1 43 23 58 60
Chief Editor: Jean-Paul Betbèze
Sub-editor: Fabienne Pesty
Contact: [email protected]
Website: http://www.credit-agricole.com - Economic Research
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No. 119 – November 25, 2008
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