Will Mortgage defaults cause a recession in the US?

Will an increase in Mortgage defaults cause a recession in the US and rest of the World?

At first glance it seems a relatively small problem. Within the US sub prime mortgage markets there has been an increase in defaults to 4.95%. The sub prime mortgage is a growing but still relatively small section of the US housing market. Nevertheless there are worries that this small incident could cause a negative multiplier effect and could push the US economy into recession. Furthermore although the US economy is not as dominant as it used to be. There are still legitimate fears that a US slowdown could spread throughout the world economy.

Why Mortgage Defaults and Problems in the US Housing Market can cause a Recession

  1. Bad Debts for Banks. Mortgage defaults are costing banks and lending institutions significant sums in debt they have to write off. For example HSBC recently had to write of $10.5bn in bad debts from the US sub prime mortgage industry. This contributed to a fall in HSBC share price. Also leading financial institutions are re-evaluating their attitude to risk. Now defaults are growing and house prices are falling they are much more reluctant to lend to what they consider risky investments. The effect of this is to reduce investment levels and therefore reduce the rate of economic growth.
  2. Loss of Confidence. The impact of consumer confidence on the economy should never be underestimated. In recent years the US economy has been buoyed by consumer spending, often financed by high levels of borrowing and rising house prices. As house prices fall and bad economic news makes the headlines; consumers will reduce spending, borrowing and increase savings. This will lead to lower AD and therefore could cause lower economic growth.
  3. Negative Multiplier Effect. The multiplier effect relates to how a problem in one economy can spread throughout the rest of the economy making the initial problem worse. For example the sub prime mortgage may only affect a small % of the population, but if those facing higher debt payments reduce their spending it effects other shopkeepers and firms. Therefore with less income coming in they may reduce their employment levels causing a further fall in AD and this negative spiral can increase (especially when confidence is low)
  4. World Recession. The US economy has been a major factor in determining economic growth in other countries. For example the US has been buying a high % of Chinese exports. If the US economy were to go into recession many countries would experience a fall in exports and therefore fall in economic growth as well. This could be exacerbated if there is a continued fall in world stock markets. However it is worth noting that the US economy is a smaller % of the world economy than it used to be. There is a growing Chinese and Indian middle class who make take up the slack in global demand.