Monday, August 20, 2007

The Fed Comments on the Wealth Effect of the Housing Boom and its Aftermath

The following from Market Watch discusses a paper released by the Vice Chairman of the Fed concerning the wealth effect of the housing boom and what could happen as a result. Based on the article the paper does not say anything particularly new, but it validates what many have been thinking for some time, namely the increasing wealth effect has juiced consumer spending. Also decreasing asset values has a more sensitive effect on consumer spending then in previous periods.

Rising home prices and innovations in the financial sector are the two biggest factors in the spike in U.S. household debt and the related decline in savings, Federal Reserve Vice Chairman Donald Kohn wrote in a research paper presented Sunday.

In a paper presented to a conference held by the Reserve Bank of Australia, Kohn and a Fed economist wrote that a "wealth effect" caused by rising home prices could boost consumption, leading in turn to an increase in household debt. Expenditures for more expensive homes are another factor behind an increase in debt, wrote Kohn and co-author Karen Dynan, chief of the household and real estate finance section of the Fed's Division of Research and Statistics.

In their paper, Kohn and Dynan noted that the personal savings rate in the U.S. has fallen from an average of 9.1% in the 1980s to an average of 1.7% so far this decade. In the same period, the ratio of total household debt to aggregate personal income has risen from 0.6 to 1.0.

Meanwhile, new financial products have reduced the cost and availability of housing finance, wrote Kohn and Dynan.

"Innovation has opened up greater opportunities for households to enter the housing market and for homeowners to liquefy their housing wealth, thereby helping them smooth consumption of all goods and services," they wrote.

Kohn and Dynan wrote that there are several reasons to be cautious about the impact of rising debt levels on the overall economy, although they noted that increased access to credit should give households the ability to weather shocks.

They said household spending is now probably more sensitive to unexpected movements in asset prices than it used to be. (my emphasis) Kohn and Dynan also wrote that some households are prone to become very highly indebted relative to income and wealth.

They noted that some U.S. households will face "significant financial distress" thanks to ongoing turmoil in the subprime mortgage market and said that regulators should consider additional rules for safe and sound underwriting practices.

Later this year, in an effort to address the fallout from that turmoil, the Fed is expected to propose rules addressing practices like prepayment penalties and evaluating a borrower's ability to repay a loan. Individuals and groups have urged the Fed to ban or limit so-called "no-doc" loans and prepayment penalties, which are the fees charged when a borrower pays off a mortgage early.

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