Debt Deflation refers to the scenario where the loan collateral (or any other type of debt) sees a decrease in value. This is generally a negative end result. It often causes the loan issuer to insist on a restructure of the loan agreement. In other cases, they may be able to demand that the loan itself be completely restructured. Other phrases that describe this concept are collateral deflation and worst deflation.
Mortgages are a great example of this to consider. They are a traditional type of secured debt. If an individual takes out a mortgage to buy a house with, then the house itself proves to be the securing underlying collateral on this mortgage loan. This means that if the buyer later subsequently defaults on the payments which he or she make to the bank each month, then the bank would begin the tedious process to repossesses the house. A problem arises when the value of the house diminishes in value at the same time that the buyer is still caught up in the process of making the payments owed to the bank. This would create a potentially devastating debt deflation downward spiral and uncomfortable situation. In severe cases, this can be enough to cause a home owner to completely despair and simply walk away from the house and its associated mortgage come what may.
This actually happened back in the Subprime Mortgage Meltdown, Great Recession, and Global Financial Crisis of 2007-2009. So many homes had been purchased in the boom period of the early 2000’s that when prices began to plunge on a breath taking national and regional scale, many buyers found themselves severely underwater on their mortgage loan collateral. The houses in many cases became worth significantly less than the principal balance on the loan which purchased them. Defaults went through the proverbial roof as many buyers realized that they had no realistic hope of seeing the value of the house rise back up.
It helps to look at an example of the despair this subprime mortgage crisis meltdown caused countless Americans, many of whom had been irresponsible, it is true. If a person had purchased a $300,000 priced house with a mortgage for $270,000 before 2006 peak pricing in the national housing market, then he or she might have sat helplessly by as the value of this same house subsequently plummeted by even 25 percent. It would meant that the $300,000 dream home was then only worth $225,000. Now in order for the house to again be worth just what the buyer owed on it, it would have to rise back up to the $270,000 mortgage total balance amount. This meant that the value had to increase by $45,000, or a staggering 20 percent, just to get back to even on the mortgage balance amount owed. In order for the house to be worth the actual $300,000 the buyer had originally paid out, it would have to rise by an even steeper $75,000, representing a whopping 33.3 percent. This would take years once the market actually bottomed out, itself a hopeless-looking procedure that require literally years before rock bottom was finally hit.
Nationally, home values that began to crash and burn in 2007 did not start to slowly crawl back up until 2011 to 2012, four to five long years later. A decade after the original crash period began many of the homes that lost 25 percent (or even far more in many cases and in overinflated-valued regions around the country) have still not recovered or just barely recovered.
It helps to explain why so many people quickly despaired and chose to default on their mortgages and to simply give the house back to the bank lender and then to walk away free and clear. Ironically in many cases, their shattered credit history and associated credit rating would actually recover faster than the value of their severely underwater home and mortgage finally did.