The Subprime Crisis: Housing Market of the United States - Research Paper Example

LITERATURE REVIEW The unique situation Numerous experts believed that the crisis would have been controlled within the platform of mortgage issuers who had clogged on the subprime loans. In fact, majority of experts never thought that the subprime fallout would be so severe to an extent of threatening the economy. While mortgage and house markets downtowns have been causes of economic problems in various parts of the world, but experts assert that this situation is unique (Simkovic 257). This study reveals that, the uniqueness of their situation explains for the first time ever downturns are motivated by a credit crisis in the non-banking area of finance, which is contrary from the norm, whereby such actions have created downturns in the general economy through a credit crisis in the banking zone. These numerous theories, which have come up to explain the root cause of the subprime crisis. Numerous experts and economists believe that a combination of factors resulted to the crisis (Lynnley 13). This study intends to examine the housing bubble as a major cause of the subprime crisis. Housing Bubble This study reveals that the present mortgage crisis started with the bursting of the U.S. housing bubble, which commenced in early 2001 and ascended to its peak in the year 2005. Essentially, a housing bubble can be defined as an economic bubble whose occurrence in both the local and international platforms in real markets id characterized by almost similar features. The housing bubble is defined by express rise in the valuations of real assets until untenable levels related to income and affiliated affordability indicators are reached (Lynnley 11). This situation leads to the decrease of home prices and debts related to mortgages, which are higher compared to the value of the assets. It is imperative to note that the housing bubble was discovered at the aftermath of the market correction that happened in the U.S in 2006. In 2007, Alan Greenspan, the former Chairman of the Federal Reserve Board indicated that, United States has been having a bubble in the housing sector (Muolo and Padilla 3-7). This came upon the realization that the house prices appeared to be overwhelmingly overvalued. The sentiments were echoed by the Richard Syron, the CEO Freddie Mac and concurred with the Yale University economist Robert Shiller who warned that the necessary correction of the bubble would be done in many years to come wit trillions of dollars being lost. This situation would lead to a double-digit decline in the home values. The housing bubble in relation to the historically low interest rates This study reveals that the majority of the experts and economists believe that the housing bubble in the United States of American was partially caused by the historical low interest rates. It is imperative to note that the Federal Reserve Board had reduced the short-term interest rates by 5.5% (from 6.5% to as low as 1 %). This was a response of the collapse of the dot-com bubble (Muolo and Padilla 3-7). This happened in early the year 2000 and was followed by the ensuing recession in 2001; however, this response significantly endangered the housing bubble through the decrease in real long-term interest rates. It is essential to note that, the US mortgages rates are set in relation to Treasury bond yields of 10 years. These rates are influenced by the Federal funds rates. This study establishes that the Federal Reserve Board acknowledged the relevance of the connection amid lower interests’ rates, increased liquidity and the higher home values in relation to the general status of the economy. On the other hand, Greenspan disputes the claim that he engineered the housing bubble. Greenspan asserts that the Fed’s decline in rates contributed to the inflation of the bubble. In 2007, Greenspan argued that, the housing bubble was not in any way related or linked to the Fed’s policy on interest rates, however, Greenspan pointed out on the international surplus in savings, which pushed down the interest rates and drove up the housing prices in nations across the globe. The former Fed asserted that the housing bubble was more of the house prices than the mortgage credit (Muolo and Padilla 3-7). The assertion indicated increase attributed to the subprime lending was a new development, which should not be related to the housing crisis, however, he did indicate that the new subprime borrowers had entered in the game late and did borrow after prices increase and hence not able to construct adequate equity before hike in the interest rates. Despite Greenspan’s defense on the housing bubble, numerous economists disagreed with this assertion. The president and CEO of the Dallas Federal Reserve Bank disputed Greenspan’s claim and asserted that the Fed’s interest policy is the sole root cause of the housing crisis. Fisher argued that, the policy’s rates amid 2000-2003 was wholly misguided by speciously low inflation data. This led to the housing simmer (Lynnley 14). Fisher outlines that that a good central banker like the Fed ought to have known how the costly imperfect data would have affected the economy. In essence, the real fed funds rate turned to be lower than what was thought to be appropriate at the period. This believe was held longer than expected and it remains evident that poor data contributed immensely to a policy action which expounded speculative activity in the housing sector and in other markets. Bursting of the Bubble This study establishes that, the Federal Reserve Board increased the interest rates more than 15 times resulting to a significant raise from 1% to 5.25%. The Fed fears that the raising of interest rates would result to an escalating downturn in the housing market would undermine the general economy compelled to an instant stoppage of the increment. However, this move does not convince the experts (Lynnley 14). Most economists felt that the Fed would have tightened up the rates much earlier in a bid to avoid decaying of the housing bubble at the initial stages. In addition, it was asserted that, the slumping sales and prices in 2006 made the housing sector to be in free fall state and this would later be linked to the derailing of the overall economy. More warnings were issued by 2006 that the housing crisis was approaching through indicators such as the median prices of new homes, which had gone down by almost 3%. Correction of Housing Market This study establishes that, correction of the housing market remained fundamental for the revival of the American economy. It is imperative that the over-valuation of the home prices during the bubble crisis affected the general economy of the U.S and proactive measures to reverse the situation remained inevitable (Lynnley 13). Several warning from economists and financial experts on the economical danger that awaited the U.S if the housing market remained uncorrected propelled the relevant boards and institutions to put up mechanism in a bid to curb the crisis. It is notable that the correction entailed reverse of diminutive points to 50% from the peak values. It is imperative to note that, other factors that my have appeared insignificant in the causing the subprime crisis played an immense to the bursting of the bubble. Some of them include the rise of subprime lending, declining risk premiums, emergence of new lenders and risky mortgage products and lax lending standards, securitization, and credit rating agencies, which gave investment, grade ratings to securitization transactions that hold subprime mortgages. The increase of the subprime borrowing The issue of rise of subprime lending or borrowing was a significant factor that led to the increase in home ownership rates. This situation is immensely attributed to the high demand for housing during the bubble period. It is imperative to note that, the American house ownership rate increased from 64% in the year 1994 to 69.2% in 2004. This kind of demand resulted to rise in consumer spending and housing prices (Simkovic 257). The consequent increase of home values ranged from 124% to 128% amid 1997 and 2006.Some owners took advantage of the situation and used consumer spending to refinance their homes wit a bit lower interest rates, which enabled them to take up second mortgages against the additional value. This practice is closely attributed to the percentage increase of the household debt in relation to the income to 130 in 2007 (Muolo and Padilla 3-7). This indicated a 30% increase compared to the previous decade. The collapse of the housing bubble created high default rates on subprime (Lynnley 11). In addition, the number of subprime loans increased as growing real estate values led to lenders taking more risks. Some economists assert that, Wall Street encouraged this type of conduct by bundling the loans into securities, which were sold to annuity funds and other institutional-based investors in a bid to seek elevated returns. Emergence of new lenders and securitization On the other hand, the emergence of new mortgage lenders contributed to the fuelling of the mortgage crisis. The lenders were specialized and not regulated in nature. These traditional lenders held 60% of the mortgage market and this facilitated the commercial banks to occupy almost 40% of the market. On the other hand, the issue of securitization played a fundamental role in the subprime fall out (Schwartz and Dash 6). It is also pivotal to note that securitization activities unfavorably influenced the screening of incentives of lenders through a mismatch of the initial loan and the bearer loan. Consequently, this had a negative impact on incentives. In fact, securitization contributed to creation of appetite for mortgage-backed securities to investors and this practice increased the risk of defaulters in a considerable rate (Simkovic 254). Resultant effects of the subprime crisis In essence, the bursting of the housing bubble influenced the federal interest rates, which climbed. It is notable that, during this period numerous foreclosures of homes bought with subprime loans had increased significantly and indication were clear that the trend would continue. This study establishes that, pervasiveness of subprime loans contributed to a 31% hike in foreclosure filings during the first half of the year 2006. All these events reached a climax, which was characterized by the collapse of the subprime mortgage industry (Schwartz and Dash 7). The housing market faced difficulties in reversing the situation since the home foreclosures rates had raised considerably and this were clear signs of collapsing of the subprime mortgage industry. Indeed the crisis led to the closer of Ameriquest, one of the largest subprime lenders in 2007. This incident sent home 3,800 employees. In addition, numerous banks, real estate savings trusts, mortgage lenders and circumvent funds suffered considerable losses due to defaults in mortgage repayment and devaluation. More over, at the start of 2008, home prices started to slowly fall. As the banks continued their lending standards, individuals with prime credit history fall back on their payments for home loans, credit cards and auto loans. It is notable that, the prime borrowers could sell their properties to repay their mortgages as homes prices fall (Schwartz and Dash 1). This situation of rise in delinquencies and foreclosures leading to fall in home prices led to broadening of the range of victims. For instance, homeless rates were indicated as families lost their homes to foreclosure. Similarly, the effects arose from the crisis affected the property owners as they faced foreclosures. In conclusion, the subprime crisis affected both financial institutions, individuals, property owners and tenants. In fact, it as been warned that if the trend continues the next victims on line are the state and local governments. It is notable that, investors lost money and even continues to lose money in the ongoing subprime mortgage crisis. Those who took mortgage from financial institutions have seen regulations change into complex obligations. Moreover, many financial institutions have become reluctant in offering mortgages, and liquidity crisis has ensued. Unless there are financial system adjustments, the subprime mortgage crisis will always be there. Works Cited Lynnley, Browning. The Subprime Loan Machine. Nytimes.com, 3 March 2007. Web. 28 Feb. 2013. Muolo, Paul and Padilla, Matthew. Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis. Hoboken, NJ: John Wiley and Sons. 2008. Print. Schwartz, Nelson and Dash, Eric. With Banks Under Fire, Some Expect a Settlement. The New York Times, 13 May 2010. Web. 28 Feb. 2013. Simkovic, Michael. “Secret Liens and the Financial Crisis of 2008.” American Bankruptcy Law Journal, 83(1), 2009, p. 253. Print. Read More