Economic impact of downturn in housing/mortgage industry in the US 2008-2010 - Research Paper Example

?Introduction The financial crisis of 2008 that was caused by the failure in the housing market has real, wide and long term implications globally. No country has been spared of the negative consequences. Major banks became bankrupt and various governments undertook to rescue their economies through economic stimulus packages. Mortgage-back securities became toxic and general stock market declined in value. Global economies are showing some indicators of recovery in 2011 and economies are stabilizing. Economic impact of downturn in housing/mortgage industry in the US 2008-2010 According to the Mortgage Bankers Association estimates drawn from four-fifths of all loans suggested that the number of loans in foreclosure proceedings nearly doubled to almost one million by the end of 2007, while 400,000 were entering foreclosure. Although, the most rapid and dramatic increase was common in the riskier subprime loans, foreclosure rates on adjustable subprime mortgages were five times higher than those on adjustable prime loans. In spite of the rate at which home owners were filing for foreclosures, not all foreclosures resulted in families losing their homes. For example estimates of loans owned and insured by Freddie Mac showed that less than half the homes with loans filed for foreclosure end up being sold. But with the hundreds of thousands of foreclosed homes flooding the already bloated markets, undue pressure was imposed on prices in places where foreclosures had reached a critical mass. In such regions nearby homeowners suffered critical declines in home equity and local jurisdictions faced a drop in property tax collections. Metropolitan areas with ailing economies, high shares of subprime, large oversupply of housing and so-called affordable loans were at the greatest risk of widespread foreclosures (Jansen et al., 2009). All levels of the government responded due to the scope of the foreclosure crisis; with efforts extended in search for lenders to make wholesale loan modifications, to expand and promote credit counseling, to aid homeowners refinance with government-insured mortgages, and to provide state and local funding to deal with the problem. During the boom-bust housing cycle, mortgage markets have suffered mightily. For instance, the boom witnessed subprime mortgages and other products that helped buyers stretch their incomes. Lenders in anticipation for higher returns, extended credit to borrowers previously unable to qualify for loans, which raised the of subprime mortgages from 8 to 20 percent. Furthermore, many loans were underwritten without a clear measure of the borrowers’ ability to repay and without cushion against defaulters. The layering of mortgage lending risks at the peak of the market posed serious far-reaching repercussions. Thus as the economy begun to weaken and mortgage interest rates rose, a rise begun in the number of homeowners not able to keep current on their payments. In turn, falling prices closed out many owners who hoped to sell their homes to avoid foreclosure. On the other hand, many house speculators defaulted long before their interest rates reset; resulting in absentee owners accounting for 20 percent of loans entering foreclosure in early 2008. Consequently, swift deterioration in subprime loan performance caught many investors unaware. Due to the declining demand for securities backed by subprime mortgages, investors were forced to sell them at a loss. Furthermore, several mortgage companies and investment funds that had borrowed to purchase the securities with debt had to roll over. For lenders who were not able to provide more money as the debts came due, some companies were forced to default and lenders had to repossess many assets. Culminating from the size of mortgage debt outstanding and the fear that the crisis would spill over to the consumer credit prompted a freeze in credit markets and runs on investment banks and funds (Ely, 2009). From mid 2007 to the end of 2008, majority of Americans lost more than 25 percent of their net worth. According to the estimates S&P 500 stock index had shed 45 percent of its 2007 high. Similarly, housing prices had declined by 20 percent compared to the 2006 peak, with the futures markets recording a 30 to 35 percent potential decline. The US total home equity that was at a high of $13 trillion in 2006, had declined to $8.8 trillion by June 2008, and towards end of 2008, the decline was progressing. A drop of 22 percent from $10.3 trillion to $8 trillion by mid 2008 was recorded by total retirement assets considered Americans’ second-largest household. In the same period, savings and investment assets and pension assets shed $1.2 trillion and $1.3 trillion consecutively. Because members of USA minority groups were awarded a disproportionate number of subprime mortgages, there has resulted a disproportionate level of resulting foreclosures. the US auto industry was also not spared, with devastating numbers for new vehicle sales recovering to only 12 million by 2010 from a 2005 peak of 17 million (Kolb, 2010). HSBC despite its rating as the world’s largest (2008) bank was the first to record a $10.5 billion loss of subprime-related mortgaged backed security immediately when the mortgage crisis was felt in February 2007. In the same year, more than 100 mortgage companies either suspended their operations, closed down or were sold. With the top management following suit, late 2007 witnessed, the CEOs of Citigoup and Merril Lynch down their tools within a week of each other. The remaining firms opted for survival tactics either by merging, or made it public that they were ready to negotiate with willing merger partners. According to Woods (2009), the crisis further thundered panic among investors and financial markets eventually forcing them to withdraw from shaky equities and risky mortgages, and instead invest in commodities. Following the collapse of the financial derivatives, resultant financial speculation in commodity futures has been blamed for the crises in world food prices and oil prices primarily due to a “commodities super-cycle.” This has been greatly impacted by financial speculators who in their desire for quick returns have withdrawn trillions from mortgage bonds and equities to put in raw materials and food. Profits for the 8533 USA depository institutions dropped by 98 percent from $35.2 billion in the fourth quarter 2006 to $646 million in the same period in 2007 Globally, August 2008 witnessed holdings of subprime related securities amounting to $501 billion written down by financial firms. A further $1.5 trillion of holdings of subprime MBSs will eventually be written down by the financial institutions. Although approximately $750 billion of the losses were recognized as of November 2008, the world banking system has been wiped of its capital by these losses. This has in turn reduced the amount of credit available to banks and in turn reduced credit to be extended to households and businesses. The September 2008 failure by Lehman Brothers and other financial institutions signaled the peak of the crisis. Cash amounting to $150 billion were withdrawn from USA money funds over s two day period in September 2008. Due to the outflow, a bank run was experienced in the money market; considering the position the role of the money market as the source credit for banks and financial institutions. Immediately after the Lehman failure, the TED spread measuring the risk of interbank lending, quadrupled; a credit freeze acknowledged to have brought the global financial system to the edge of a collapse. In counteraction, the European Central Bank, Federal Reserve and other central banks responded immediately by purchasing US$2.5 trillion of government debt and troubled assets from banks. The purchase is termed as a historic monetary policy action and largest liquidity injection into the credit market, in the history of the world. In congruence, the purchase of newly issued preferred stock in their major banks enabled the governments of USA and European nation to generate the capital of their national banking systems by $1.5 trillion (Kolb, 2010).Although some third world economies such as China and Brazil are not expected to suffer as much as those of developed countries, some studies point towards Brazil’s own subprime crisis. A total loss of more than of $1 trillion on bad loans and toxic assets is estimated by the International Monetary Fund as a combined loss by large European and US banks from January 2007 and September 2009. By 2010, the losses are expected to top $2.8 trillion. According to World Bank (2009), the downturn in mortgage industry led to massive job cuts and skyrocketing unemployment rates globally. It is estimated that over 3.6 million people in the United States of America lost jobs in 2008 and additional 2.4 million people became jobless in 2009. Furthermore, the unemployment rates in the United States rose from 6.2 percent in December 2008 to 9.2 percent (14.1 million unemployed people) in July 2011 (BLS, 2011). The highest unemployment rate was experienced in November 2009 of 10.2 percent, which was the highest unemployment rate in 26 years. The International Labour Organization revealed that there was an estimated 50 million job losses in 2009 globally as a result of the downturn in mortgage industry. The rising unemployment rates were experienced by both emerging market and developed economies. The International Labour Organization estimated that there will be over 200 million job losses during the economic crisis in the construction, financial services, and real estate as well as construction industries. Employees who are lucky to remain in their employment are facing benefit cuts as both business and non-business entities cut on cost as they try to survive the economic turbulence. Increasing unemployment rates was also reported in Italy The downturn in mortgage industry affected major banks of developed countries especially those in the United States as well as those of United Kingdom. When the subprime mortgage market collapsed, liquidity crisis squeezed the economies and banks had little money for their daily operations. Consequently, twenty five banks in the United States became insolvent in 2008 and seventy seven more banks became insolvent as at 14th August 2009. The economic crisis caused by failure in the housing market increased public debts levels significantly and there was diversion of key resources to rescue the dying mortgage market. It is in record that Former United States President George W. Bush and his successor President Barrack Obama each signed economic stimulus packages named Emergency Economic Stabilization Act of 2008 and American Recovery and Reinvestment Act of 2009 respectively. Bush’s economic stimulus package was worth $168 billion while Obama’s was $ 787 billion. Both economic stimulus packages cost money, which was derived from the taxpayers to pay for economic sins that was perpetrated by government agencies and profit hungry financial institutions. Some of the banking institutions rescued by the United States government are Goldman Sachs and Morgan Stanley (Muolo 2008). Table 1: Different countries with Debt-to-GDP changes for 2008-2010 Country 2008 2010 Percentage change Canada 64 77 20.3 France 67 80 19.4 Germany 67 87 29.9 Italy 106 121 14.2 Japan 196 227 15.8 United Kingdom 52 73 40.4 United States 71 98 38 Source: IMF 2009 The Debt-to-GDP ratio is all the above countries increased significantly between 2008-2010 periods that coincided with hard economic times caused by the failure in the housing market. The Debt-to-GDP increased because the cost of stabilization was added to public debt. Investors, lenders and borrowers were the hardest hit in the economic downturn precipitated by subprime and reckless lending in the United States. During the crisis, investors panicked and lost confidence in mortgage-backed security market. The investors tried to liquidate and exit the market as soon as they started realizing losses in their investments (OECD 2011). Furthermore, investors refused to accept adjustable-rate mortgages as collateral for issuing commercial papers backed by assets. This created liquidity crisis in lending institutions, which systematically spread to other markets. The ability and incentives of lending institution to issue loan or create credit was either eliminated or drastically reduced. The banks also restructured their products and fee structures as they incorporated additional economic scenarios and risk factors into their product portfolios. Abrahams and Zhang (2009) ascertained that borrowers were forced to pay higher monthly payments as a result of upward adjustment of subprime loans. Economic crisis caused equity values and housing market to decline. It also forced lending institutions to tighten their credit and underwriting standards, which made it difficult for borrowers to refinance their loans through additional borrowing. Consequently, defaults and foreclosures ensued. The other implication of the failure in the housing market was the increase in currency volatility. Exchange rates of nearly all countries have changed tremendously. There has been a significant exchange rates fluctuation that has increased the cost of international trade globally. Following the collapse the of Lehman brothers in September 2008, the dollar has appreciated against both the British Pound and the Euro. This is as a result of dollar illiquidity in world financial markets as well as reduced appetite for risk globally. Currencies in developing countries have not been spared either. According to Free (2010), currencies that have been pegged to either the Euro or British Pound have depreciated against the dollar and currencies that have been pegged to the dollar have appreciated significantly. If currencies appreciate, it reduces competitiveness in the international trade. The financial crisis reduced gross domestic product of the United States. Furthermore, rising unemployment and falling asset prices has contributed largely to sharp decline in consumer spending (SESRIC 2009). Emerging economies and developing nations have experienced decline in prices of their commodities and demand for their exports. In addition, some migrants have started returning to their home countries while those who remain are remitting less of their hard earned money to their homes due to the economic crisis. Unlike before the crisis, it more difficult to borrow money in the United States than it was before the economic crisis. In addition, planning to own a house through mortgage has been made even harder because stringent measure have been introduced to vet people who apply for mortgage. On the other hand, people who own homes have been terrified as the value of their homes decline dramatically. The economic crisis has increased the gap between income groups in the United States. The richest 1 percent in the United States owned 34.6 percent country’s wealth. However, after economic crisis 1 percent population in the United States own about 37.1 percent of the country’s wealth (Kolb 2010). Conclusion Financial crisis have caused sluggish economic growth. People from different countries have suffered from loss of growth and income from their investments. The interest rates dropped significantly, forcing savers and lending institutions to devise ways to keep up with biting inflation. Investing companies as well as individual investors have watched with abated breath as stocks in companies they invested in stagger or drop tremendously. People who have worked hard to built their savings and invest in mutual funds for retirements are in for a rude shock because stock values are also nose-diving. The economic crisis of 2008-2010 has eroded values of stocks significantly and retirees fear for their future. To sum it all, economic crisis of 2008-2010 devastated global economies beyond measure and sound financial policies should be devised and adopted to prevent future financial catastrophes. References Abrahams, R. C., & Zhang, M. (2009). Credit Risk Assessment: The New Lending System for Borrowers, Lenders, and Investors. New York: John Wiley and Sons. BLS (2011). THE EMPLOYMENT SITUATION. Retrieved from http://www.bls.gov/news.release/pdf/empsit.pdf Ely, B. (2009). Bad Rules Produce Bad Outcomes: Underlying Public-Policy Causes of the US Financial Crisis. Cato Journal, 29 (1): 93. Free, C. R. (2010). 21st Century Economics: A Reference Handbook (Vol. 1). London: Sage Jansen, L. H., Beulig, N., & Linsmann, K. (2009). US Subprime and Financial Crisis - To what Extent Can You Safeguard Financial System Risks? GRIN Verlag: Munich. Kolb, R. (2010). Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future. New Jersey: John Wiley. Muolo, P. (2008). $700 billion bailout: the Emergency Economic Stabilization Act and what it means to you, your money, your mortgage, and your taxes. New York: John Wiley and Sons. OECD (2011). OECD Economic Surveys: Italy 2011. France: OECD Publishing. IMF (2009). Global Financial Stability Report. Washington, DC: International Monetary Fund. SESRIC (2009). Annual Economic Report 2009. Ankara, TURKEY . Retrieved from http://www.sesric.org/files/comcec25/AER09_eng.pdf Woods, T. E. (2009). Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse. Washington DC: Regnery Publishing, Inc. World Bank (2009). World Development Indicators 2009. Washington: World Bank Publications. Read More