Stephen King: The reality of housing and debt risks

How about this for good timing? America's central bank, the Federal Reserve, published a paper on 8 August (The Rise in US Household Indebtedness: Causes and Consequences) with the following, prophetic, words: "As illustrated by the recent developments among sub-prime mortgage borrowers, excessive accumulation of debt can, in some circumstances, lead to financial distress. Moreover, the reaction of financial markets to these developments raises the possibility that credit availability could be hampered for a larger group of households, which could, in turn, have effects on the broader economy."

The authors of the paper (which is available at www. federalreserve.gov/pubs/ feds/2007/200737/200737pap.pdf) are Karen Dynan, the chief economist of the Fed's household and real estate finance division, and Don Kohn, the Fed's vice-chairman and, thus, Ben Bernanke's deputy.The authors look at causal hypotheses and suggest some are more important than others. Thus, there is little evidence to suggest households have become increasingly impatient in their desire to consume, which might have contributed to a culture of "buy now, pay later".

Equally, there's not much evidence to support the idea households have become less risk-averse, thereby reducing their need to save for "precautionary" purposes. Lower interest rates over time have played a role but explain only a modest amount of the reduction in savings. Demographic change, specifically the impact of baby boomers getting older, has had some influence, though, again, only a modest one. The authors conclude: "The most important factors behind the rise in debt and the associated decline in saving out of current income have probably been the combination of increasing house prices and financial innovation."

Higher house prices encourage people to borrow more for all sorts of reasons. If house prices rise relative to incomes, those wanting to buy a new home may have no choice but to borrow more. Those with a home may feel richer as the market price of their property rises, enabling them to borrow to buy the gleaming SUV on the local car dealer's forecourt. Creditors, meanwhile, may be happier to lend more to households because the collateral backing the additional loans - the value of the property - is now higher.

Financial innovation is closely connected to this story. The authors note not only that more households can get access to credit but also that those households who were always creditworthy can now borrow a lot more. "The financial system has evolved in important ways over the past several years, including improved assessment and pricing of risk; expanded lending to households without strong collateral; and more widespread securitisation of loans, which has likely lowered the cost of credit."

All of this may be true. Debt levels have been rising for decades in the US. Despite fears to the contrary, Americans are mostly a lot better off now than 30 or 40 years ago. Higher debt, on its own, isn't a problem. It becomes a problem, though, when borrowers wish they hadn't been so profligate or when lenders suddenly ask for their money back. Events over the past few weeks suggest we are now entering "problem" territory.

The reasons are not hard to fathom. On the whole, technology and the associated improved flow of information may have led to better assessment and pricing of risk, but sometimes markets get it wrong, particularly when a financial innovation has a limited history, as is the case with sub-prime mortgages, asset-backed collateralised debt obligations and all the other financial products which have been hitting the headlines. Knowing that, on the whole, risk is better managed does not imply that, on all occasions, it's better managed. Panic ensues when things go wrong because the underlying long-term assumptions - that markets tend to get things right - are thrown out of the window.

The sometimes poor assessment of risk is not only a problem for the creditors. Those households who've added to their debts in recent years are also likely to have "mis-priced" risk.

In another Federal Reserve paper published in 2006 (Do Homeowners Know Their House Values and Mortgage Terms?), Brian Bucks and Karen Pence noted: "Most homeowners appear to report their house values and broad mortgage terms reasonably accurately. Some adjustable-rate mortgage borrowers, though, and especially those with below-median income, appear to underestimate or not know how much their interest rates could change." (see www.federal reserve.gov/pubs/feds/ 2006/200603/200603pap.pdf.) Bucks and Pence based their findings on the 2001 Survey of Consumer Finance. Since then, there's been huge growth in adjustable-rate mortgages and a big expansion of sub-prime lending. It would be nice to thinkthose who borrowed on these terms might, over time, have better understood the risks they were facing but I doubt it.

The driving forces behind higher consumer debt have been predominantly rising house prices and financial innovation. The housing market, though, has been softening for a good 18 months. And recent weeks suggest the appetite for financial innovation will dwindle. Either way, the implication appears to be at the very least a slower rate of debt accumulation and, at worst, a significant reduction in debt levels, either because households won't want to borrow or, more likely in the short-term, creditors won't want to lend.

More conservative attitudes towards debt may, in the long run, be a good thing. Greater transparency of products to reveal where, precisely, risks lie would also be a step in the right direction. In the months to come, however, the main focus is likely to be the impact of anxious capital markets on US consumer spending. If credit standards are tightened, the US consumer will be vulnerable on at least three fronts. The housing market may take another leg down, reducing the collateral against which consumers can borrow. The availability of discounted mortgages, self-certification mortgages and 100 per cent mortgages will dwindle, again reducing access to credit. And households may discover previous rate rises begin to bite, as adjustable-rate mortgages are reset at higher rates and the discounts on so-called teaser mortgages come to an end.

The Federal Reserve papers provide good explanations for the rise in household debt in recent years. The papers also, implicitly, provide a roadmap for what happens when everything goes wrong. For policymakers, it's time to dust off their map-reading skills.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com