CAMBRIDGE – With less than two months remaining before America’s presidential election, much attention is focused on the state of the American economy and the challenges that it will present to the next president.
We are in the midst of a financial crisis caused by the serious mispricing of all kinds of risks and by the collapse of the housing bubble that developed in the first half of this decade. What started as a problem with sub-prime mortgages has now spread to houses more generally, as well as to other asset classes. The housing problem is contributing to the financial crisis, which in turn is reducing the supply of credit needed to sustain economic activity.
Indeed, the financial crisis has worsened in recent weeks, reflected in the US Federal Reserve’s takeover of quasi-government mortgage lenders Fannie Mae and Freddie Mac – which may cost American taxpayers hundreds of billions of dollars – as well as the bankruptcy of Lehman Brothers and the sale of Merrill Lynch. Ultimately, these financial failures reflect the downward spiral of house prices and the increasing number of homes with negative equity, i.e., with substantial mortgage debt in excess of market values.
Negative equity is significant because mortgages in the United States are generally “no recourse” loans. If a homeowner defaults, creditors can take the house, but they cannot take other property or income to make up any unpaid balance. Even in those states where mortgages are not “no recourse” loans, creditors generally do not pursue the assets or income of individuals who default.