The U.S. foreclosure crisis: a two-pronged assault on the U.S. economy

Tatom, John (2008): The U.S. foreclosure crisis: a two-pronged assault on the U.S. economy.

Abstract

The U.S. mortgage loan foreclosure crisis has been called “the worst financial crisis since the great depression.” There are two distinct channels of influence of the subprime problem. The first is the rise in foreclosures that affects homeowners and the real estate industry most directly. The second channel is financial, flowing from the effects on lenders’ financial viability and on financial markets. The timing of developments in these two channels will determine how fast markets work through these problems and restore stability and growth to the nation’s housing and financial markets. The problem is rooted in the housing market, and this market is likely to be very slow to adjust. It takes time for good mortgages to go bad and to then move through to the end of the foreclosure process. While financial markets work much more quickly, they will be held hostage to the unfolding effects of the foreclosures in the housing markets and among lenders. Mortgage loan related losses will continue along with foreclosures over the next year or so and these losses will plague firms even if they have already taken adequate write-downs on their asset values. Complicating the picture is the response of the Federal Reserve, which has reacted chaotically by creating new lending programs that have transformed its credit supply from government securities to private financial institutions, and in the process, violated the first rule of central banking to lend liberally in a liquidity crisis. This failure, compounded by providing a backstop to questionable securities, has slowed market adjustment and risks lengthening and deepening the financial crisis. This paper reviews the emergence of the foreclosure crisis and its real impacts in the economy, the financial market effects of the surge in mortgage foreclosures, the monetary policy response to the problem, and provides an assessment of the outlook for the crisis.

• Item Type: MPRA Paper
• Language: English
• Keywords: Mortgage foreclosure, credit crunch, credit channel, subprime lending
• Subjects: E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E50 - General; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks ; Depository Institutions ; Micro Finance Institutions ; Mortgages

References

Aglietta, Michel and Laurence Scialom, “ Permanence and Innovation in Central Banking Policy for Financial Stability,” paper presented at the International Banking, Economics and Finance Meetings, Honolulu, July 1, 2008.

Bernanke, Ben S., Mark Gertler and Simon Gilchrest, “The Financial Accelerator in a Quantitative Business Cycle Framework,” in Handbook of Macroeconomics, vol. 1C, Handbook in Economics, vol.15, Amsterdam: Elsevier, 1999, pp.1341-93.

Bethel, Jennifer E., Allen Ferrell and Gang Hu, “Legal and Economic Issues in Subprime Litigation,” John M. Olin Center for Law, Economics and Business, Harvard University, Discussion Paper 02/2008, February 2008.

Board of Governors of the Federal Reserve System, Federal Reserve System Purposes and Functions, ninth edition, 2005.

___________, “Highlights of Proposed Rules to Amend Home Mortgage Provisions of Regulation Z,” Dec.19, 2007. http://www.federalreserve.gov/newsevents/press/bcreg/highlightsregz20071218.htm

___________, Federal Reserve Statistical Release H.4.1, August 2, 2007 and March 28, 2008 issues.

Burckhardt, Galen, “Volume Surges Again: Global Futures and Options Trading Rise 28% in 2007,” Futures Industry, March/April 2008.

Chapman, John L., “Fighting Recession with Panic,” The American, March 18, 2008.

Crews Cutts, Amy, and William Merrill, “Interventions in Mortgage Defaults: Problems and Practices to Prevent Home Loss and Lower Costs,” Freddie Mac Working Paper #08-01, March 2008.

Demyanyk, Yuliya and Otto Van Hemert, “Understanding the Subprime Crisis,” paper presented at the Federal Reserve Bank of Chicago 44th Annual Conference on Bank Structure and Performance, May 16, 2008.

Federal Deposit Insurance Corporation, Quarterly Banking Profile, May 29, 2008, and earlier issues.

Federal Reserve Bank of St. Louis, U.S. Financial Data, May 23, 2008.

Gerardi, Kristopher, Harvey Rosen, and Paul Willen, “Do Households Benefit from Financial Deregulation and Innovation? The Case of the Mortgage Market,” National Bureau of Economic Research, NBER Working Paper No.W12967, March 2007.

_______, Adam Hale Shapiro and Paul Willen, "Subprime Outcomes: Risky Mortgages, Homeownership Experiences, and Foreclosure,” Federal Reserve Bank of Boston Working Paper 07-15, May 2008.

Greenlaw, David, Jan Hatzius, Anil Kashyap, Hyun Song Shin, “Leveraged Losses: Lessons from the Mortgage Market Meltdown.” U.S. Monetary Policy Forum, New York, New York February 2008.

Greenspan, Alan, “We will never have a perfect risk model,” Financial Times, March 17, 2008.

International Monetary Fund (IMF), “Global Financial Stability Report: Containing Systemic Risk and Restoring Financial Soundness,” April 2008.

Kaufman, George, “Lender of Last Resort: A Contemporary Perspective,” Journal of Financial Services Research, Vol. 5, 1991, pp. 95-110.

Lex column, “Eyes Wide Shut,” Financial Times, May 23, 2008.

Mian, Atif R. and Amir Sufi, “The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis,” NBER Working Paper No. W13936, April 2008.

Mishkin, Frederic S., “Housing and the Monetary Transmission Mechanism,” Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Board of Governors of the Federal Reserve System, 2007-40, August 2007.

Organization for Economic Cooperation and Development (OECD), “The Subprime Crisis: Size, Deleveraging and Some Policy Options,” April 2008.

Reinhart, Vincent, “Our Overextended Fed,” Wall Street Journal, March 26, 2008a.

__________, “Fallout from the Bailout,” Washington Post, May 2008b.

Sarkozy, Olivier and Randall Quarles, “Private Equity Can Save the Banks,” Wall Street Journal, June 26, 2008.

Schwartz, Anna J., “The Misuse of the Fed’s Discount Window,” Federal Reserve Bank of St. Louis Review, September/October, 1992, pp. 558-69.

Sherlund, Shane M., “ The Outlook for Subprime Adjustable Rate Mortgages,” Board of Governors of the Federal Reserve System, May, 2008.

Juster, F.T., J.P. Lupton, J.P. Smith, and Frank P. Stafford, "The Decline in Household Saving and the Wealth Effect." Review of Economics and Statistics, 88(1): 20-27. 2006.

Tatom, John A. “Why Is the Foreclosure Rate So High in Indiana?” Networks Financial Institute, NFI Report 2007-NFI-04, August 2007.

Torres, Craig, “Fed ‘Rogue Operation’ Spurs Further Bailout Calls,” Bloomberg.com, May 2, 2008.

Trainor, Mike, “Credit Risk-Backed Lenders Report Significant Growth Amid Credit Crunch Chaos,” Global Association of Risk Professionals, Today’s Risk eNews, RiskCenter.com, May23, 2008.

Wheelock, David C., “Replacement Windows,” Federal Reserve Bank of St. Louis Monetary Trends, May 2003.

Williams, Andrew, “Industry Risk-Summary of Terms and Conditions Regarding JPMorgan Chase Facility,” Today’s Risk eNews, Risk Center.com. March 25, 2008.