Wednesday, July 18, 2007

How Do Mortgage Defaults affect the economy?

There has been a lot of press recently about problems in the US housing Market. Basically, the US housing market has witnessed a growing number of home-owners being unable to meet their mortgage payments. The problems are concentrated in the sub prime mortgage sector.

(sub prime mortgage refers to people with bad credit histories such as missed payments, previous defaults e.t.c)

As a result, of mortgage defaults many sub prime mortgage lenders have gone bankrupts, including, New Century Financial Corporation, previously America’s second biggest sub prime lender.

See: Why has the US Housing Market gone from Boom to Bust?

The effects of this sub prime collapse are widespread and can adversely affect the economy in a variety of ways.

Problems of Sub Prime Defaults

1. House Prices likely to Fall.

Because people cannot afford to pay their mortgage payments, they may be forced to sell their houses. Also, the collapse in the sub prime lending market is making lenders much more cautious about future lending. Therefore, this is increasing the supply and reducing the demand. This is a significant factor in causing house prices to fall.

2. Falling House Prices reduce Economic Growth

House prices are a significant determinant of:
i) consumer confidence
ii) Consumer wealth

A fall in house prices reduces consumer wealth, reducing the potential for Remortgaging and gaining equity withdrawal. Also, falling house prices leads to a general decline in consumer confidence. House prices are often seen as a barometer of the state of the economy. The fall in consumer confidence will reduce the rate of economic growth and could even cause a recession in the US.

3. Companies writing off Losses.

The sub prime defaults affects the parent companies who have stakes in them. For example, the US conglomerate GE, recently bailed out of the sub prime market by selling its sub prime mortgage division [1] It blamed the $373 million decline in profits on bad debts from sub prime lending. Because companies such as GE have a decline in profits, there is less scope for business investment. Furthermore, it helps to undermine confidence in the stock market and general economy.


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