These strains in household finances from suddenly excessive debt service burdens are met by households in a variety of ways: through default, foreclosures, and bankruptcy, or renegotiation of the terms of repayment, but also through continued higher principal and interest payments accompanied by much lower consumption than the household had previously planned. As we see in Chart 1 (Employment declined dramatically) job losses in the recent recession were extremely large and prolonged, a problem that resulted, in part, in significant delinquencies in debt repayment. Furthermore, the significant decline in house values imposed a much stricter limit on how much households could borrow if they needed, for example, to adjust to the effects of a temporary loss of income. Recent economic research has examined how the macroeconomy is affected when households suddenly experience reduced borrowing capacity. Eggertsson and Krugman consider the case of households that have borrowed up to some limit and now see their debt limit reduced; these households suddenly find themselves over-indebted and are forced to cut spending.1 If the required cuts in spending are large enough, then even a very active monetary policy will be unable to offset them completely. Other research has also suggested similar mechanisms.
2  BIS Review 132/2008  Within a day, AIG had to be rescued following rumours about the size of its losses on CDS contracts and pressures grew on the remaining securities dealers. Later in the week, Secretary Paulson announced his initial $ billion plan to purchase assets to support the banking sector. It didn’t entirely still the doubts. The pressures were also felt in Europe. At the end of September Dexia, Fortis and Hypo Real Estate all had to receive emergency capital injections, mostly government supplied. In the UK the authorities facilitated a rapid consolidation in the mortgage sector with Abbey Santander buying Alliance and Leicester, some mergers in the building society sector, and the proposed merger of LTSB and HBOS. Finally, in late September the Tripartite authorities intervened to resolve growing difficulties in Bradford and Bingley by transferring the deposits and branch network to Abbey Santander and taking the remaining assets and liabilities into public ownership for orderly wind down. But the loss of confidence went wider than a subset of vulnerable banks. Our report estimates the total US and European marked to market losses on credit assets at nearly $ trillion. While these will not all fall on banks and may exaggerate the losses to those who can hold debt to maturity, investors and counterparties became worried about the extent of the likely losses on banking and trading books in a wider range of institutions and in their ability to continue to finance their businesses.