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The national economic crisis was triggered by the red ink of millions of American homeowners who refinanced their homes, not the trading pits of Wall Street or the boiler rooms of fraudulent lenders, according to a new study released nearly one year after the stock market plummeted worldwide recession began.

Did Household Debt Trigger Worldwide Recession?

Mian_and_Sufi.pdf

The national economic crisis was triggered by the red ink of millions of American homeowners who refinanced their homes, not the trading pits of Wall Street or the boiler rooms of fraudulent lenders, according to a new study released nearly one year after the stock market plummeted worldwide recession began.

A new study by researchers at the University of Chicago’s Booth School of Business found that a surge of runaway household debt-mortgages, second mortgages and home equity loans-beginning in 2001 became so unsustainable by 2007 that it brought the world’s economy to its knees.

Moreover, this is not the first time excessive household homeowner leverage preceded a severe economic downturn, and it won’t be the last unless policy makers, regulators and researchers must recognize the central role of household financial health in causing economic turbulence. “The central lesson we as economists have learned from the crisis is that an unsustainable increase in household debt is one of the most serious threats to the U.S. economy,” concluded researchers Atif Mian and Amir Sufi.

Cheap mortgages drove housing demand and soaring prices. High prices encouraged existing homeowners responded to the increase in house price growth by borrowing heavily against the increase in the value of their home equity until debt reached unsustainable levels. Homeowners extract $0.25 to $0.30 in cash from their houses for every $1 of growth in house price.

Rising interest rates and deteriorating interest rates spawned the first wave of defaults, which, though modest by today’s standards, were enough to send a shock wave through the financial system. To make their payments, households cut back on consumption as the personal savings rate reached 4.3% in the first quarter of 2009 - the highest it has been in a decade.

The impact on the real economy was immediate. Starting in the first quarter of 2006, residential fixed investment growth began a dramatic decline. By the fourth quarter of 2007, residential fixed investment had declined almost 50% from its 2005 level. By the end of 2008, the household de-leveraging process was in full swing, and it is likely to be the major headwind facing the economy going forward, the study concluded.

U.S. economic downturn has been most severe in counties that saw the most aggressive borrowing during the housing boom. Low leverage growth counties completely avoided the housing downturn. But counties that had experienced the largest increase in their debt to income ratio from 2002 to 2006-and where home prices rose the most-saw a tremendous rise in household default rates. Auto sales contracted as homeowners cut back on spending. As early as the middle of 2007, unemployment rate increased more sharply in counties that had experienced the largest increase in their debt to income ratios.

By bailing out struggling financial institutions, the political response to the crisis made the crisis worse “During booms, institutions have the incentive to take large bets and structure themselves in such a way as to make their failure unpalatable to regulators during busts. Similarly, the electorate demands action during economic downturns which can promote excessive public spending. Indeed, our biggest worry is that we are simply replacing a private debt problem with a bigger public debt problem,” Mia and Sufi concluded.

For a copy of the study, click on the link at the top of this story.

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