Housing Markets in the Financial Crisis of 2008 - Essay Example

Housing Markets in the Financial Crisis of 2008 The housing markets played a tremendous role in the business world that resulted into the financial crisis that was experienced in the year 2008. Due to the easily accessible mortgages from the banks the housing industry experienced a boom in that the number of new houses being built increased exponentially. This exponential increase in the number of houses being constructed was referred to as the housing bubble. The bubble was surrounded by irrational exuberance which went further to create a suitable environment for financing. This financing, which was commonly called ‘cowboy’ financing increased the housing bubble growth to abnormal proportions (Baker, 2008, 73). In this essay the causative circumstances of the bubble are described. Later on there is a discussion about how the various financial decisions that were made which when coupled together with the shortage of proper structure for regulation in the financial sector led to the abnormal growth of the bubble to levels so dangerous that in the end led to the crash. The origin of the housing market boom The boom in the housing market started growing as the stock bubble grew up in the last decade of the 20th century. In simple terms, the logic governing the growth of the housing bubble was one such that the wealthy were spending the money they had accumulated from the favorable stock markets (Baker, 2008, 73). The stock prices had run up in a manner extraordinary and many people had not anticipated. The wealthy therefore started spending at a rate similar to the rate of wealth accumulation. The increased wealth resulted in an increase in the average consumption and it was noted that the savings rate sourced out of every individual’s disposable income experienced a fall from 5% in 1995 to about 2% in the year 2000. The wealth gained from the favorable stock markets led to massive investments in the housing industry as people strived to buy bigger houses and to make better homes. The supply of housing is, of course, fixed so this therefore meant that the sudden increase in demand was likely to cause the housing bubble effect (Baker, 2008, 73). This caused a chain of events starting by an increase in demand which automatically resulted in the house prices to rise. As the prices started rising in some of the areas affected there was a unique phenomenon such that the prices started being incorporated into expectations and these made the buyers of houses and homes to start paying more than they would otherwise have done. This had a tendency of making the expectations self fulfilling and more convincing. Research together with the data from the government’s documents pointed to a very slight change in the house prices for over 100 years before the beginning of the house bubble. Even as the price of the houses rose, the rent did not increase in a similar manner but it in fact remained trailing behind in a modest manner a clear indication that the price of the houses was as a result of the housing bubble (Baker, 2008, 74). The instantaneous increase in the price of the houses both for buyers and those renting them started creating a substantial effect on the supply side as a result of the rise in price from around 1995 towards 2000. The house prices rose up to about 25% in the year 2002. This was above the average rate of the three years from 1993 to 1995. This then resulted in to an effect that appeared as an oversupply in the number of rental housing sector for it caused the vacancy rate to rise to about 9% in the year 2002 which was 1.5% increase to that of around 1990 that stood at about 7.5%. It was believed that the collapse in the stock bubble would subsequently lead to the collapse of the housing bubble just as was the case in Japan. Unfortunately this did not happen since the two cases were different on many fronts thus when the stock bubble in the united states collapsed, it did not result into the collapse of the housing bubble but instead acted as the feed for the bubble. When the stock prices fell tremendously, people gave up in the investment in the stock market and this made more investments were directed into the housing sector as a result of the loss of faith in the stock market. It is important to note that at this time when people were developing loss of faith in the stock market prompting then to seek for alternative investment, the economy was on the other hand recovering slowly from the recession that affected the country in 2001. This recession resulted into continued shedding of jobs through the year 2002 a slightly calming down in the year 2003. The weak rate of recovery forced the Federal Reserve Board to initiate measures that resulted into cutting interest rates. This in turn pushed the rate for the federal funds down to 1%. This consequently led to the lowering of the mortgage interest as a measure to follow the rates for the federal funds. At this time Mr. Alan Greenspan who was the Board chairman of the Federal Reserve gave an advice that what the customers were doing could be described as wasting their money on the fixed rate mortgages (FRM) instead of thinking of Adjustable Rate Mortgages (ARM). This further fueled the housing market since in as much as it sounded as a peculiar advice especially taking into consideration the low rate f fixed Mortgages rate, it was a fact that the larger mortgages were still affordable due to the adjustable rates that were existing at the time. The interest rate was extraordinarily low and this therefore accelerated the number of houses being built or bought in at any particular time period than the previous years. The house price rose by 32% from the last quarter of 2002 to 2006. This further fueled more constructions to about 50% above the rate that was being experienced in the years before the bubble (Baker, 2008, 73). This had a consequent effect on consumption in that it boomed over the period consequently affecting the savings rate to fall to a value below 1% in the period from 2005 to 2007. The housing bubble opened its jaws on the economy of the United States in the year 2007 since the boom in the housing sector had led to the supply overpowering the demand and there was the switching of the vacancies from the rental basis to the ownership basis in 2006. As the housing bubble continued to reign it tended to create dynamics that were self-perpetuating. This created an opposite force in form the crash dynamics which were also self-perpetuating in a direction opposite to the previous and more home-owners faced foreclosure as the prices for the houses continued to decline. The increased risk for foreclosure was in some instances voluntary and in others involuntary (Baker, 2008, 74). The involuntary represents the group of the people who would like to keep their houses at all costs even if it meant borrowing against equity in the instance that they were in a position to meet their mortgage payments as required per month. This option was destroyed whenever the falling house prices destroyed equity. As for the case of the voluntary foreclosures, this represents those people who come to the realization that whatever they owe is more than the value of their homes and appreciate the fact that the approach of paying off their mortgage will be a bad deal. In such a situation or case in which the value of the home I slower than the outstanding mortgage, the wise homeowners simply walk away from the homes thereby keeping for themselves some thousands (or even hundreds of thousands) of dollars. Whether the cause of the foreclosure is voluntary or involuntary is not what matters because both of them have the effect of increasing the supply of housing. Foreclosures were at about 2.8 million annual rates in early 2008 and this represented about 60% of the sales rate that existed in the first quarter of the year. In some corners of the United States that were hit hardest by the foreclosures, it is reported that they exceeded the home sales that were existing at the moment. This in effect forced the lower house prices led to an increase in the supply of houses as a result of forcing for more closures (Alexander, 1998, 14). This resulted into a similar dynamic developing on the demand side in that as a result of the growing investment in the housing sector, the lending standards experienced an ever increasing laxity. This prompted the soaring of default rates in the period 2006 to 2007. The banks in this particular period began to use more tight standards which included demanding larger down payments. The markets with prices falling more rapidly experienced the most severe tightening such that the lenders in such market started demanding down payments of about 20% and even in some extreme case this value rose to 25%. This in turn discouraged and excluded many homebuyers from the market. This did not only affect those who were buying houses for the first time but it also affected even the already existing home owners found it difficult to make the large down payments. This was mainly as a result of the highly falling prices of the houses that had caused equity destruction. When equity is destroyed it is obvious that the victim is never in a position to bargain against the oppressive forces of the mortgage (Zuckerman, 2010, 60). As the year 2007 approached its end, there was a drop in the prices of houses in the real estates of more than 15% from the initial peak. In other areas such as the two coasts where houses had been overvalued on the markets there was a recorded drop of more than 20%. It was noted that the price declination rate was accelerating such that the prices were falling at a rate more than 30% (Zuckerman, 2010, 40). Excesses associated with the housing bubble. The prices of the houses continued to go further outside the premeditated fundamentals prompting the financial industry to adopt financial innovations that were more sophisticated so as to aid in its growth. The most notable aspect was the growth of the mortgages that had no outlined standard commonly referred to as ‘non-standard mortgages’ for they had adjustable rates. Before the boom started being experienced in the middle of the last decade in the 20th century most mortgages that existed operated on a fixed rate basis. This however was changed when the boom knocked the financial doors which then resulted into the development of the mortgages with the adjustable rates which became the first choice for the many who sought the mortgages during the time (Lewis, 2010, 54). In the period between the years 2004 and 2006 for example, the percentage of the adjustable rate mortgage applied for by those seeking mortgages was standing at 35%. These mortgages had two major problems associated with them in that; they did not provide the necessary security as that provided for in the fixed rate mortgages and that they were, in most cases, issued with rates that were below those ones of the market which would then increase extremely after a few years even if there was no rise in interest rates (Baker, 2008, 75). Angelo Mozilo, the former chief executive of mortgage lender Countrywide Financial Corp did illegal insider trading of mortgages leading to the financial crisis. Countrywide was the leader in the subprime mortgage market, whose collapse in 2007 touched off the financial crisis that has held the U.S. and global economies. Mozilo is the key individual to blame for the crisis. The mortgage market’s sub-prime segment experienced this type of mortgages to a larger extent. The sub prime mortgages referred to the loans that were usually issued to people with poor histories in matters of credit; in simpler terms people with previous cases of default in the payment of the loans to the lending bodies. Most of the homebuyers that were subjected to the sub prime segment mortgages were those people whose employment records raised a lot of questions or even those that had been known to default in the previous loans they took before the boom (Zuckerman, 2010, 56). Effect of wrong incentives The housing bubble caused a surge in the number of high risk loans which was encouraged by the existence of misplaced incentives in the selling and financing sides of the housing sector. The appraisal process provided the best instance and/or example to indicate the extent of misplaced incentives. In typical terms, the appraisers can be referred to as people that operate on independent contracts and in most cases are usually hired by the banks or any other issuer of mortgages for individual appraisal. It was a normal practice for the banks to value an honest appraisal with the aim of ensuring that the collateral being engaged in would have the value of the loan covered (Baker, 2008, 79). The situation, however, was different during the boom in the housing sector, since the issuers of mortgages during this time, earned their money whenever they issued the loans contrary to the conventional practice in which they earned their money by holding on the mortgages (Lewis, 2010, 75). This therefore made the issuers to target levels of appraisal that would justify the issued mortgage in the end. This therefore meant that their target was high appraisals creating a bias that quickly descended on the appraisers. This was after the appraisers discovered that in order to secure a position in the next hiring by the bank they had to come up with high appraisals to in order to allow for the issuance of loans (Baker, 2008, 76). Some banks bought loans and later on bundled them into Mortgage Banked Securities commonly known as MBS and went further to make money from the fees associated with them. In order to sell the MBS whose loans were of questionable quality demanded the securing of good credit rating of the bonds. This therefore forced the banks to start issuing Collaterized Debt Obligations (CDOs) that included mortgage backed securities together with other assets and which would offer aspects of layered financing in which bonds of higher quality would have first payments. The desire to increase income from the fees associated with MBSs is the same scenario with the actions to issue both the Alt-A and the Subprime Mortgages that were highly questionable. In both cases the fees led to the attainment of large profits that lasted for a short time. It is worth explaining the principle behind the CDOs cash flows. The Fixed Income Securities are repackaged and the division of their cash flows is done strictly with reference to a waterfall structure. The CDO exists only through the creation of Special Purpose Entities (SPEs) or Structured Investment Vehicles (SIVs). These buy assets and are also involved in the issuing of bonds that are usually backed by the cash flows of the assets. This therefore meant that the banks would sell bonds against the SIVs hence keeping the liabilities associated off book. This period saw an overwhelming increase in the Credit Default Swaps (CDSs) which provided reliable security for the lenders against risks. These risks included the default associated with assets of questionable quality. These saw a massive spread of the CDSs which in turn allowed the smaller state and/or local governments together with small firms to sell their bonds. This was done knowing that their credit would have a backing from the banks that were issuing CDSs. It is important to understand the origin of the CDSs. These are believed to have come into use in the last half of the last decade in the 20th century. Many refernces however connect the origin of the CDSs to BISTRO which was an acronym for the Broad Index Securitized Trust Offering that was created to in 1997 by the company, JP Morgan. This was intended at ensuring that the company was not riskily exposed to the loans made to borrowers (corporate) such as Ford and IBM. Due to the requirements of regulatory capital the company’s ability had been constrained by the unfunded commitments and such loans. Conclusion As outlined above the housing markets played a significant role in the financial crisis that occurred in the United States in the year 2008. It is evident that unregulated financial practices that may appear to have an advantageous impact on the economy at a given instance may end up creating the worst crisis that might as well end up overshadowing the benefits associated with the practices (Inquiry Commission, 2011). Works Cited Baker, Dean. “The Housing Bubble and the Financial Crisis.” Real-World Economics Review. 1.46. pp. 73-81. 2008. Print. Lewis, Michael. The Big Short. US: W.W. Norton & Company. 2010. Print. Zuckerman, Gregory. The Greatest Trade Ever. Crown Business. 2010. Print. Inquiry Commission. The Financial Crisis Enquiry Report. US GPO. 2011. Print. Alexander, Hoffmaister. “Contagion,Bank Lending Spreads and Output Fluctuations.” Working Paper W6850.Cambridge, MA: National Bureau of Economic Resources. 1998. Print. Read More