Introduction to Macroeconomics #1 - "An analysis of the household leverage and the 2007-2009 recession"

INTRODUCTION
This article investigates the reasons behind the 2007-2009 financial crisis, and the topical issues that characterized it. The first question that we should ask ourselves is, how it is possible that a national mortgage default turned into the most severe economic crisis from the Great Depression.
The answer to this question is certainly more complex and heterogeneous than the evidences provided here, and a complete analysis of it is far beyond the scope of this work. This stated, we will underline two of the most important elements that lead to market collapse: household leverage and credit card borrowing.

HOUSEHOLD LEVERAGE
To introduce household leverage, we should first understand how the mortgage market changed during the years preceding the crisis. To do this, the very basic consideration to be made is that the loan applicants can be split in two main categories: 1) the prime lessees and 2) the sub-prime lessees.
In this analysis, we will only consider the second group. Sub-prime lessees were usually applicants with a very bad credit history, which means they were unlikely to repay their loans if the interest rates requirements started to rise. Hence, common sense should suggest to release the less amount of loans possible to sub-primes, given the high risks involved into this practice. But, as we all know, common sense is sometimes just an abstract concept.
Household leverage is defined as the amount of money that all adults in the household market owe financial institutions. This amount raised dramatically during the years 2002-2006, and the main reason behind that is the so called “securitization”. Securitization is a financial engineering process that transforms an asset belonging to real economy, as a mortgage loan, into a marketable security. The process can be explained in a relatively simple way: when a bank releases a loan, this loan can be pooled into a financial instrument called mortgage-backed security (MBS), with thousands other loans, and sold in the secondary market to investors. The interests that homeowners paid to the bank as for contractual issues, were channeled from the bank to investors, that received a regular premium for undertaking the risk of owning MBSs. Hence, it is easily understandable that this cycle is possible only when loans are repaid, and this condition only occurs if the creditworthiness of lessees is high enough to face possible increase in the interest payments due to the bank. Furthermore, MBSs were split into different risk-level tranches (from AAA to Equity tranches), and sold to a wide range of investors, from hedge funds to pension funds to retail investors. This gave banks the possibility to earn much more than before by selling loans, especially because they could ask higher premiums for riskiest tranches. In addition to this, this loan supply change that occurred from 2002 to 2006, was backed by another financial instrument: the collateralized debt obligation (CDO).

Breaking down CDOs
Collateralized debt obligations (CDOs) are derivatives that were created to push higher the potential returns that investment banks did during the household market explosion. If, say, some of the riskiest tranches of MBSs were not sold, because considered too likely to default, they were pooled and repacked into a CDO: given that these tranches belonged to different MBSs, they were considered diversified, and credit rating agencies, mostly because paid by investment banks, gave them a AAA rating. Thus, they were sold to the market as a very secure and stable instrument, even if in reality it was very likely to default, given the risky nature of the tranches it was built of.
One fundamental thing we must understand is: why diversification was not applicable? In the case of a CDO, the diversification that occurs is only quantitative and not qualitative, meaning that that asset from which this instrument derives its value, it is entirely linked to household loans. For extent, if the sub-prime system started to collapse, the contagion to CDOs’ value was complete and not diversifiable.
The expansion of household leverage
The percentage of lower-quality subprime mortgages originated during a given year rose from the historical 8% or lower, to approximately 20% from 2004 to 2006. This uncontrolled lending perpetrated by banks and rental agencies dramatically increased house prices, but with an important collateral effect: the more prices increased, the more lends were released. This vicious cycle was mainly driven by the banking sector’s avidity, that created a lending system oriented to enlarge banks’ returns more than to ensure the stability and the sustainability of market’s growth.
Furthermore, the facility to buy and sell this CDOs on the market lead to a global contagion that, when the household bubble blew up, created a hole equal to half of the world’s GDP and more than 10 million unemployed people.
The household market collapse
These CDOs were composed of adjustable-rate mortgages, used for predatory lending on “subprime” lessees, that were unlikely to pay if interest rates started rising. The main features of this type of derivatives were: 1) the interest rate they were based on were extremely convenient for sub-prime lessees, that as we said were not able to repay them if rates increased; 2) they had a reset period, after that the interest value was recalculated based on the perception of the market’s default risk. But, as in 2007 the rates started resetting due to the worsened economic outlook, sub-primes could not afford them anymore, and the default cases arose. By 2009, the default rate neared 10%, and the total delinquent debt (owed but not returned repayments) amounted to $1.7 billion.

THE DEBT BORROWING
Another issue that implemented the impact of the crisis, was that homeowners started borrowing 25 to 30 cents per every dollar of increase in price of their property, extracting cash from their home equity and accumulating a deep debt between 2002 and 2006. In addition, they mostly used this borrowings for undertaking new loans (for houses, boats, cars, durable goods in general), exponentially amplifying the household leverage. When the crisis hit, the overall demand for residential investments plummeted, deeply lowering the prices of properties and making impossible for debt borrowers to repay it by extracting new cash from their houses’ equity (this mechanism is applicable only when the price increases). As a consequence, by the end of 2007, the residential fixed investments plummeted 50%.

CROSS-SECTIONAL ANALYSIS AND CREDIT CARD BORROWING
Given by the fact that economic linkages make it hard to conclude what factors contributed to the recession of 2007-2009, the researchers focused on cross-sectional variation and data collection from several sources (Zip Code, etc.) across U.S. counties. Out of 3,138 counties in the United States, the top 450 had been chosen. Furthermore, these 450 counties were covering 70% of the U.S. population and 82% of the aggregate debt outstanding as of the end of 2005.
How much household leverage growth in specific counties from 2002 to 2006 affected the counties recession from 2006 to 2009? There are five county-level economic outcomes the researchers analysed in order to present the correlation between household leverage and economic outcome. Through the approach of differentiating between high and low leverage growth counties, each economic output can be visualized and shows both the timing and severity of the recession. Counties that experienced the largest increase in their debt to income ratio from 2002 to 2006 generally were hit earlier and more severe by the recession. In the second quarter of 2006, the mortgage default rate sharply increased in high leverage counties while low leverage counties only experienced a modest increase. The patterns in house price growth are somewhat similar but in the beginning of 2006, house prices began to plummet and dropped significantly by 40% in high leverage growth counties. In contrast, low leverage growth counties entirely avoided the housing downturn and due to the elasticity in housing supply, prices remained stable. Counties with the largest income to debt ratio from 2002 to 2006 also experienced a strong contradiction in auto sales and housing permit growth in the early stage of the economic downturn while low leverage growth counties were affected only later. The most important measure of recession severity is the unemployment which began much earlier in high versus low leverage growth counties.
In addition to that, the researchers developed a general equation which explains economic outcome as a function of variables such as leverage growth and measures like cyclicality, demographic or industrial composition.

Economic Outcomei = β x Leverage Growthi + Γ x ControlVariablesi + εi

Household leverage is an indicator of economic activity. The next step is to examine the relation between consumer credits and financial crisis. Credit availability demonstrates the banks’ willingness to lend. According to the data, credit card availability was expanding during fourth quarter of 2006 to the third quarter of 2008, although home equity and mortgage credit markets were tighter in the early part of the recession. Besides, high-leverage growth counties were still borrowing on credit cards. Some explanations to this effect are either a last attempt to avoid defaults or a final draw down before bankruptcy.
In the credit analysis on auto sales, the data indicates that credit card utilization rate is not related to auto sales growth in the early quarters of recession, but that it is strongly correlated during the entire recession. As for the analysis on housing permits and unemployment, the correlation is not substantial.
Also, some arguments state that the severity of the recession is due to an aggregate credit contraction to businesses. However, the statement is not persuasive for the following reasons. First, business investment in equipment and software did not decline until the first quarter of 2009. The drop can be interpreted as a reaction to the reduction in consumption. Second, studies suggest that enterprises were in a much healthier financial situation than consumers. Third, covenant violation and default rate support the fact that firms faced less distress than they did in the recession of 2001.
In summary, household balance sheets are a crucial component of explaining macroeconomic fluctuations to some extent.