Mortgage mortality

Much has been written about the crisis in the US credit markets that has brought down major investment banks...

Much has been written about the crisis in the US credit markets that has brought down major investment banks, seized up credit and paralysed Wall Street. What sparked it off? We know that something strange happened in the American real-estate market 8212; where 8220;sub-prime8221; borrowers, or those who didn8217;t have a history of good, timely payments, were given lots of home loans that, eventually, they couldn8217;t pay. We also know that complex financial contracts 8212; derivatives 8212; which were meant to spread the risk of those defaults around, stopped working, or had been given completely the wrong price, leading to much insecurity in the markets about who had what risky loans on their balance sheets. What we don8217;t know is why it happened when and where it did.

Some people might claim that the trigger for a financial unwinding could have come from anywhere; but, even so, why did it come from real estate, and why was it in America? A new paper, published last week by Luci Ellis, an economist at the Bank of International Settlements 8212; a central bank for central banks 8212; attempts to provide an answer, to explain a very special kind of American exceptionalism.

As she points out in the paper, parts of which are extracted alongside, many other countries had real estate markets that first boomed, than slowed; nowhere else did so many people stop paying, and eventually, through those arrears and defaults, cause chaos. She carefully analyses the various things that made the US housing market unique. For example, defaulters 8212; and those who file for bankruptcy because of mortgage payments 8212; are treated with considerably less severity in American legal codes than in most other places.

Of the several interconnected contributing factors she comes up with, two stand out. The first is the 8220;elasticity of supply8221; of housing in America. This means that, in the US, markets can react very quickly to small changes in price by building lots more houses. The US, of course, has the most developed, quickest markets in the world; and that8217;s a good thing, usually. It means that demand can quickly be satisfied, but if the demand goes away, productive capacity moves on to other things. In this case, when the prices went up, more houses were built; but as demand started going down, the houses were still there. There8217;s a difference between such durables and other goods.

The second is that, in the end, the US was a victim of its own love for a society of home-owners. Home-loan payments were privileged, tax-exempt; this meant people bought more houses, sometimes for speculative purposes 8212; 8220;flipping8221;.

The financial markets8217; troubles aren8217;t entirely because of real estate. But, in large part, they are. Knowing why those markets exploded, as Ellis explains, is crucial to try and avoid it happening again 8212; or somewhere else, such as India.