The prime mortgages on credit availability

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. Investors bought some of these pooled assets without understanding the true risks.

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.