Low Rates and Mortgage Debt

The mortgage debt market is the largest debt market in the U.S. Before the credit crisis, the housing market was expanding at a high rate. From mid-2003, when interest rates fell to 5.1 percent, through the beginning of the credit crisis (mid-2008), the debt outstanding grew 63 percent (see the above chart). Since then, it has fallen 4.8 percent. While low rates caused an explosion of mortgage debt, they had little overall impact on corporate and federal debt. Corporate debt has grown slowly and independently from interest rates. Federal debt grew steadily since mid-2001, only to take off due to the government’s attempts to remedy the crisis, growing 41 percent from mid-2008 to September 2010.

The growth in different sectors’ debts gives some insight into the mechanism whereby low rates fueled the economy. While we cannot say that corporations did not benefit from low interest rates, one would have expected their debt to have grown faster with low rates if their borrowing played a major part in fueling the economy through its previous woes (the Internet bubble, the effects of the 9/11 terrorist attack, the 2002 stock market crash, etc…). And, while we do not know exactly what was done with the money borrowed by home buyers and homeowners, the huge growth in mortgage debt does lead one to suspect that homeowners made substantial use of low rates and high home prices to remove a large amounts of equity from their homes.

The large growth in mortgage debt compared to the relatively flat level of corporate and federal debt leads one to believe that the previous economic troubles were largely mitigated through homeowner spending fueled by their use of low rates to leverage the housing bubble.

With the housing market deflated, and banks unwilling to make nonconforming loans, this is unlikely to happen again, as is evidenced by the drop in outstanding mortgage debt since mid-2008.  If this is the case, how exactly will low rates help revitalize the economy today?

More information about interest rates and mortgage debt can be found in my article Analysis of Mortgage-Backed Securities: Before and After the Credit Crisis, which can be found in the new book Credit Risk Frontiers: Subprime Crisis, Pricing and Hedging, CVA, MBS, Ratings, and Liquidity.