The foreclosure crisis: a two-pronged attack on the U.S. economy

The U.S. mortgage loan foreclosure crisis has become the biggest risk facing the U.S. economy. In August 2007, the National Association of Business Economists named the combined effects of subprime debt defaults and excessive personal and corporate debt as the greatest short-term threat to the U.S. economy. There are two distinct channels of influence of the subprime problem that raise concern. The first is the rise in default and foreclosure that affects homeowners, lenders, neighborhoods and the real estate industry most directly. The second channel is financial, flowing from the effects on lenders’ financial viability and on financial markets. The second channel has become more visible and dominant in popular discussions of the issues since mid-August 2007. This paper discusses the emergence of the foreclosure crisis, these two channels and their likely depth, timing and implications. The timing of developments in these two channels will determine how fast consumers and business work through these problems and restore stability and growth to the nation’s housing and financial markets. The bottom line is that the problem is rooted in housing markets and these markets are likely to be very slow to adjust and to eliminate difficulties. It takes time for good mortgages to go bad and for bad mortgages to move from delinquency in payments to the initiation of the foreclosure process. It also takes time from initiation of the process until the process ends with the sale of a property to a new owner and the distribution of the losses to affected parties. Thus no matter how quickly financial markets adjust, the effects of the foreclosure problem, even those working though financial markets, will continue to play out for at least another year. The paper also discusses the initial dimensions of the financial crisis and the extent to which it originated in or involved a credit crunch. It ends with a discussion of the prospects for the financial crisis.