America's Mortgage Meltdown

THE bursting of America's housing bubble in the northern summer of 2006 triggered the global financial crisis and recession.

The sharp fall in house prices that followed dramatically reduced household wealth, leading to lower consumer spending and a fall in gross domestic product. By now, wealth in the form of owner-occupied housing is down about 30 per cent, equivalent to a loss of more than $US6 trillion ($A7.2 trillion) of household wealth.

The fall in house prices also led to a sharp rise in mortgage defaults and foreclosures, increasing the supply of houses on the market and causing further price falls. As a result, a third of all American home owners with mortgages are already ''underwater'' - their mortgage debt exceeding the value of the house. For a sixth of the homes, the debt is 20 per cent higher than the price of the house.

In addition, high loan-to-value ratios in the US combine with household financial problems to increase the number of defaults and foreclosures. More specifically, rising unemployment means more people cannot afford their monthly mortgage payments.

Unlike most other countries, US has a "no recourse" residential mortgages system. If an owner stops making payments, the creditor can take the property but not other assets or part of wages. Even in states where creditors have the legal authority to take other assets or wages, personal bankruptcy laws are so restrictive they don't bother to try.

Although it is tempting to think of this as a problem affecting only the US, nothing could be further from the truth. When home owners default, banks lose money, and uncertainty about the extent of future defaults undermines confidence in banks' capital, making it harder for them to raise funds and causing them to reduce lending to conserve their resources.

As a result, the recession has been deeper and longer and the weakness of the US economy will lower US import demand. And, if house prices continue to fall, so will the value of mortgage-backed securities held by the world's financial institutions, affecting the supply of credit far beyond the US.

Recent data suggests the fall in house prices may be coming to an end. The rate of decline of US house prices fell in the three months to May, and the figures for May show essentially no decline. If the trend continues, it will prevent further erosion of household wealth and strengthen the banks' capital positions.

But the data, while encouraging, may be the result of temporary factors. Mortgage interest rates fell below 5 per cent in March and April, but have risen significantly since. Moreover, government subsidies to first-time home buyers may have released pent-up demand. And the banks' voluntary moratorium on foreclosures may have kept supply off the market.

All of this may have caused a temporary rise in house prices. In short, we will have to wait for the house prices data for June and July to know whether there has been a permanent turnaround.

The recent rise in existing home sales in the US may also be misleading, since many are foreclosures. Indeed, property that has been foreclosed, or is on the verge of foreclosure, now accounts for nearly a third of all existing home sales. Foreclosed property is generally sold at auction, guaranteeing a buyer but driving down prices. Significantly, foreclosures rose 7 per cent month on month in June, and a whopping 32 per cent compared with June last year.

The Obama Administration has enacted legislation to help individuals who are finding it difficult to meet their monthly mortgage payments because of a decline in their incomes or a rise in the interest rate. For those with high mortgage payments, the US Government will share with the creditor bank the cost of reducing the payment to 31 per cent of disposable income.

This is a new program, and it remains to be seen how well it will work to prevent defaults. Some limited previous experience with mortgage modifications is not encouraging. Nearly half those whose mortgages were modified nevertheless defaulted within six months.

Unfortunately, there is no program to deal with the defaults and foreclosures caused by high loan-to-value ratios. Given the large number of negative-equity home owners, there is a risk that defaults and foreclosures will continue. If they do, the sale of foreclosed properties will continue to depress house prices, reducing household wealth and hurting financial institutions.

Unless house prices have stopped falling, it is important for the Obama Administration to turn to the problem of high loan-to-value ratios. That would help not only the US economy, but also the economies of all of America's trading partners.

Martin Feldstein, a professor of economics at Harvard, was chairman of president Ronald Reagan's Council of Economic Advisers and president of the National Bureau for Economic Research.