Why the US?

There were so many other countries and markets where credit was booming and asset prices have been high.

There were so many other countries and markets where credit was booming and asset prices have been high. In many other countries, housing prices were rising even more rapidly; risk spreads in debt markets were low; and highly leveraged merger and acquisition activity was extremely strong8230; propagation of the crisis is not the subject of this paper. Rather, the question posed here relates to the underlying defaults, and why they occurred in US mortgages.

How did it happen?

Construction boom created excess supply Between 2001 and 2006, the United States built more new homes than would seem to have been required by the growth in its population. In contrast, countries such as Canada, the United Kingdom and Spain barely managed to build enough homes to keep up with growth in the number of households.

Lending standards declined more in the US

Mortgage lending standards eased in my countries in recent years, but the limited available cross-country evidence does suggest that the process went further in the United Statesiquest;.An array of statistical evidence and legal findings shows that underwriting standards of individual lenders eased as well. First, and perhaps most importantly, requirements for documentation of income and assets became progressively laxer. Instead of assessing borrowers8217; abilities to service their loans, lenders ended up focusing on collateral values, in effect betting on rising housing prices.

What institutions led to this?

House-building responds quicker to price changes in the US

The elasticity of housing supply is higher in the United States than in countries such as the United Kingdomiquest;Now that the boost to demand from easier credit has been withdrawn and homes a long distance from employment centres have become less attractive as gasoline prices rise, it seems hard to imagine that this supply overhang will be worked off quickly, without a substantial fall in prices in these regions.

The tax system privileged house-owning

In the United States, unlike in most countries, interest on mortgages for owner-occupied homes is deductible against income tax. The imputed rent from owning one8217;s home and not paying rent to a landlord is likewise free of tax. Both of these aspects of the tax system encourage households to buy their own home. Encouraging home ownership has long been an explicit policy goal in the United States, so these differences in taxation arrangements are not surprising. One effect of them, though, is that US households have less incentive to pay off an owner-occupied mortgage quickly.

Over-reliance on household credit ratings

While credit scoring clearly reduces costs and increases transparency in mortgage origination Committee on the Global Financial System 2006, it holds a number of potential dangers. Firstly, analogously to credit ratings for structured credits, households8217; credit scores can be used for purposes for which they were not designed. The FICO score was designed to assess risks on credit cards and other short-term consumer credit, but was also used for mortgage lending.

Securitisation encouraged over-expansion

Demand for structured credit products did not just influence the behaviour of existing mortgage lenders. It seems that it also encouraged entry into the market. In particular, many major US investment banks and some international ones acquired subprime lending subsidiaries during the boom8217;s run-up phase8230;While the investor appetite for asset-backed instruments encouraging the securitisation boom was global, it manifested itself the most in the market where securitisation was used the most. Whether this was due to the size of the underlying mortgage market, its denomination in US dollars, or the willingness of lenders there to ease standards to meet that demand, is not immediately clear.

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Extracted from a paper by Luci Ellis, available online at bis.org