Impact of the US Mortgage Crisis

During 2007, the so-called ‘subprime mortgage crisis’ originated from the United States economy. The crisis originated from high mortgage defaults, largely as a result of the confluence of rising interest rates and falling house prices.

Between June quarter 2004 and September quarter 2006, the US Federal Reserve increased its federal funds rate from 1 per cent to 5.25 per cent. While the rates were lower, large volumes of money were lent to high risk (subprime) borrowers. As interest rates increased and housing prices stalled, reducing the equity borrowers had to draw on, subprime mortgages increasingly fell into default. It is estimated that 16 per cent of subprime mortgages were in default at August 2007, and that outstanding subprime mortgages totalled around US$1.3 trillion.

To date, the crisis has affected the Australian economy primarily through ripple effects in the stock market and the re-pricing of risk in the short-term credit market. Between 24 July and 17 August 2007, the Australian All Ordinaries index fell by 12.3 per cent following news of the severity of the crisis in the US. The All Ordinaries took two months to recover its pre-crisis position.

Concurrently, overnight on 24 July 2007, the margin between the Reserve Bank of Australia’s cash rate and the 30-day bank accepted bill rate, a proxy for the short-term credit market risk premium, jumped from 0.12 per cent to 0.21 per cent. This risk premium increased as high as 0.56 per cent—equivalent to two average Reserve Bank rate increases—by 12 September 2007. The margin has not recovered to the pre-crisis level, and the average premium since 24 July 2007 has been 0.29 per cent, compared with 0.1 per cent from 1 January 2007 to 24 July 2007.

The longer-term impact of the crisis on Australia is unclear. While the All Ordinaries index has recovered, banking and credit related stocks remain volatile. The re-pricing of risk premia has led to stagnation in credit markets and to the demise of at least one non-bank lender (RAMS Home Loans). The crisis, and consequent fall in confidence in the US, has assisted in the strengthening of the Australian dollar.

The long-term risks from the crisis may become clearer as significant numbers of US adjustable rate subprime loans are re-priced in 2008. This may result in further market effects as lending institutions reveal their exposure to bad debts and the costs of refinancing wholesale loans. The crisis could also continue to affect global demand due to a less confident US economy, and the effects of higher long-term credit risk premia may hamper the ability of all people and businesses to borrow.

Library documents
Adrian Makeham-Kirchner, ‘Home Loan Interest Rates and Repayments (November 2007 Revision)’, Background Note, Parliamentary Library, Canberra, 2007–08.’

Documentation
Michael Liedtke, ‘A Primer on Subprime Mortgage Meltdown’, Associated Press, 12 March 2007.