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More On The Housing Boom and Bust; Cause and Effect

Dennis Norman

While there has been much discussion about the causes and effects of the Housing Boom as well as the Bust (including by yours truly in prior posts) I don’t think we need to refrain from continuing to examine this part of history that is affecting millions of people across the country. Perhaps we can learn some lessons from this that will help us avoid another such collapse of the housing market in the future.

My topic today actually has a silver lining of sorts. The topic is debt and how so many homeowners across the country leveraged themselves into a mountain of debt during the housing boom only to later have that mountain collapse on them. My attention was drawn to this subject by a presentation done by Karen Dynan of the Brookings Institution entitled “Household Leveraging and Deleveraging“.

American’s Debt Grew At a Much Faster Pace Than Income

As you can see from the chart below the percentage of American’s disposable personal income that is needed to pay debt payments on mortgage and consumer debt peaked in the mid to late ’80s just over the 12 percent range but then dropped back down to just below 11 percent by the early 90’s. By the height of the real estate boom this percentage had grown significantly and peaked at just under 14 percent in 2007. Clearly the cost of home ownership during the boom was increasing at a faster pace than homeowners income.

debt-service-ratio-chart

Chart by Information St. Louis, Inc. - Data Source Board of Governors of the Federal Reserve

Dynans’ report attributes the rise in debt to having probably been “the combination of increasing house prices and financial innovation.” I think “financial innovation” is a nice way to describe sub-prime, interest only and other such creative ways to finance homes that became prevalent during the boom.

As the chart below depicts, consumers mortgage debt grew dramatically during the housing boom even though “other debt” remained fairly constant.

Source: Household Leveraging and Deleveraging - Karen Dynan

“Everyone” Was Borrowing – Not Just Sub-Prime Borrowers

Contrary to what is sometimes portrayed, it wasn’t just sub-prime borrowers that were racking up debt during the housing boom. The chart below shows a fairly consistent increase in household debt across several demographics.

Source: Household Leveraging and Deleveraging - Karen Dynan

Obviously this rather rapid and intense increase in household debt, particularly mortgage debt, is a major factor behind the record number of mortgage delinquencies and foreclosures we are currently seeing. Rising home prices (at astonishing rates in some markets) during the boom forced many homeowners to take on more mortgage debt than they should. Many even admit buying homes with initial “teaser” interest rates realizing they would not be able to afford the payment in two years when the teaser is gone, but simply planned to sell the home (at a profit) beforehand and move on. This, like musical chairs, works until the music stops as it did in 2007.

The Importance of Defaults

If you have defaulted on your mortgage or lost a home in foreclosure, you are helping out our economy! Well, sort of. According to Dynan’s report, the record rates of charge-offs by lenders of mortgages as a result of defaults and foreclosures that have occurred in the past year has resulted in mortgage debt in 2009 declining 2 percent rather than staying flat.

Source: Household Leveraging and Deleveraging - Karen Dynan

Now for the Silver Lining-

I promised you a silver lining and here it is. American’s now have less household debt! Beginning with the 2nd quarter of 2008 consumers home mortgage debt, after increasing over a trillion dollars just two years before, actually decreased and has continued decreasing every quarter since. Consumer started decreasing as well in the 4th quarter of 2008 but has grown slightly again in the 1st quarter of this year.

Source: Household Leveraging and Deleveraging - Karen Dynan

In addition, as the debt-service chart at the beginning of this post shows, the portion of income that is necessary to pay debts for the American consumer has fallen over 1 percent from it’s peak and is still headed downward.

Is This Self-Control Or Is There No Choice?

Ah, critics could argue that the consumer has not really learned anything from the housing bust and the only reason debt has dropped is that banks and other lenders aren’t lending. Well, it is certainly true that lending standards have tightened significantly and bankers are acting like, uh, well, bankers again (the pre-boom ones) as shown by the chart below. However, Dynan’s report indicates that 20 percent of senior loan officers reported in May 2010 that demand for consumer loans had fallen relative to 3 months earlier. Probably better proof that consumers are exercising self-control is the MBA mortgage application survey which, in recent weeks, have shown a decrease in mortgage applications from both home-buyers as well as home owners seeking to refinance.

Source: Household Leveraging and Deleveraging - Karen Dynan

What Does The Future Hold In Store?

Karen Dynan suggests that we are going to see consumers continue the trend of reducing debt. She bases this on the high ratio of average household debt to assets which, as the chart below illustrates, peaked in the past year at a level that was 50 percent higher than in 2000.

Source: Household Leveraging and Deveraging - Karen Dynan

Dynans’ report goes on to say the following about the future:

  • Mortgage charge-offs are likely to remain high
  • Foreclosures will be on the rise again after being delayed by HAMP and other factors
  • Even when lender’s ease up, new borrowing is going to be dampened due to borrowers lacking home equity
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