What Caused the Bubble and Bust in the US Mortgage Market - Term Paper Example

? THE BURSTING OF BUBBLE IN THE US MORTGAGE MARKET The objective of this paper is to study the structure and mechanism of the mortgage market and in the light of these characteristics, analyze the factors that led to its ultimate demise. Identification of the problematic areas within this subject will facilitate the process of finding adequate solutions to those problems through policy changes and other measures that will restore the economy back to its original progressive stance. Introduction In the year of 2007, the world witnessed an economic crisis of a magnitude unimaginable in today’s sophisticated times withal its detailed planning, theories and innovations. Some compared it to the Great Depression of 1930s. It began with the crashing of the US Mortgage Market that is one of the most active sectors in the US economy. Gradually, it spread to the financial of many other countries and in 2008 one of the biggest investment banks in UK, the Lehman Brothers, crashed. Though the crisis affected the financial sector resulting in problems pertaining to banking, it soon got transmitted to the real sector through a fall in employment and output. The ultimate effect was an economic slowdown. (Muller, 2010, p.1) In this research, we will analyze the factors that led to the crash of the US Mortgage Market and contributed to a large-scale financial crisis. The US Mortgage Market To identify the factors responsible for the bursting of the bubble in the US Housing sector, its structure and mechanism has to be studied in detail. General structure The US mortgage market has been one of the oldest sectors in the US economy. The structure of this market is complex and in order to understand its mechanism it is important to study the interactions between the primary and secondary markets. Twenty five years ago, the mortgage market was dominated by the primary sector local banks and local Savings and Loan (S&L) which was run according to a set of rules and regulations. The mortgages were held till the time the loans matured and were refinanced in one way or the other. But, from 1980s onwards the banks and S&L discovered that more profits can be made by the securitization and sale of these loans to investors, retaining only the servicing functions the fees for which will be paid to it. As a result, of securitization, the banks, now, did not have to wait till the maturity of loans since they have already been bundled and sold off to investors in return for its monetary value. Consequently, lending of credit increased earnings per share increased and the dividend to shareholders and corporate increased as well. Loans were bundled as per the requirement of the investors and sold to the one offering the best rate of interest. Soon, the primary sector banks and S&L were completely driven out from taking part directly in the mortgage market. It was, now, ruled by the secondary sector organizations, investment and mortgage banks. These banks formed a circular system with no lender of last resort like the FED or government bank and S&L. (Kim, 2010, p.139) Mechanism of the Bursting of Bubble in the Housing sector The secondary sector banks engaged in mutual securitization and purchase of one another’s loans. Also, due to lack of regulatory measures in the market, information about borrowers was either not verified or it was foreclosed, in the greed of making more profits and expanding. This resulted in an increase in the number of Non-Performing Assets (NPAs). The effect of each NPA on the mortgage market was magnified due the large number of layers created and it corroded the credit base. Finally, as the negative effect from these NPAs outweighed the overall wealth of these organizations, the entire mortgage market collapsed. Thus, the banks in the financial sector suffered severe losses and people withdrew their money from these banks. In 2007, two hedge funds, the High Grade Structured Credit Strategies Fund and the High Grade Structured Credit Strategies Enhanced Leverage Fund had reported losses due to their exposure to the mortgage market. Investors lost confidence in the shares of these hedge funds and withdrew money. As a result, these two organizations collapsed and even capital injections could not rescue them out of the crisis. (Global Economic Crisis Research Centre, 2010, p.26) The decay of the financial sector resulted in credit-rationing and thus, less investment in the economy. This led to a fall in employment generation and output (real sector variables) and finally, a slowdown of the economy. Reasons for the Bursting of Bubble in the Mortgage Market There were a number of factors that contributed to the collapse of the mortgage market in USA. Among these are three important factors that had a direct bearing on the incident. These are the \speculation, carelessness in the process of lending, and increasing interest rates on mortgages. Rate of interest on mortgages had always been low in the US. Davis, Lehnert and Martin conducted an experiment on the valuation of houses in US based on data from 1960 to post-1995. They conducted this experiment by calculating the rent-price ratio of houses. During the period 1960 to 1995, this ratio remained consistent but it showed a sharp decline from 1995 onwards. For this ratio to reach its consistent high level, the price level of houses was required to fall by approximately, 3%. Therefore, they concluded that value of houses would fall by 3% in the period after 1995. This clearly showed that the US mortgage market was over-valued. However, the proponents of this theory did not take a tough stand while there were others who drew up contradictory conclusions. The reason was that economics still does not have a complete understanding of the reasons and time of price deviations in the long term. (Watcher & Smith, 2011, p.52) The US government policy on mortgage and other loans is that higher interest rates are charged on riskier assets and lower interest rates on assets that are less risky. Due to this policy, late payment and defaults on loans of all kinds, including mortgages decreased during the period of 2004-06. This led the banks to believe that these assets were not as risky as calculated. As a result, the procedures of verification of information about borrowers were relaxed. Sub-prime mortgages increased as did a number of other loans like the NINJA (No Income, No Job and Asset) loans. There was no down payment or a negligible amount of down payment on these loans and the only way to earn profits on them was by bundling them up together and selling them to investors. This led to an increase in the layers or leverages of the credit base and increased its vulnerability. This means that the effect of each NPA would be magnified and felt directly and indirectly on all the banks or mortgage organizations connected to it. The ultimate result was an explosion of NPAs on the credit base of the US Mortgage market. (Baumol and Blinder, 2010, p.781-782) A sudden, unexpected increase in the interest rate led to the inability of a number of homeowners to pay mortgage. Mortgage defaults were increasing at a rate of 10% during the period 2008-09. As a result, sales and valuation of houses decreased. There was a fall in the sale of houses by 78% and prices of houses fell by 30% from 2005 to 2008. This was followed by a decrease in the value of securities. By 2010, 12 million loans, i.e. one-fourth of the total housing debts, were reported to have exceeded the value of appraisal. Thus, the US mortgage market was doomed. (UN: Economic Commission for Europe, 2010, p.16) This proved to be the final nail in the coffin of the US mortgage market. Interpretation of Facts and Figures From the analysis of all the facts and figures given above, it is evident that the collapse of the mortgage market in US, that caused the global financial crisis, occurred primarily due to a negative wealth effect. The main reason for this is a massive mistake in speculating the value of real estate. Since the value of houses was on an upswing, people expected it to rise even further. The probability that the value of houses may fall was hardly considered, even though some economists found statistical proof to support this claim. The theory that the value of real estate is likely to fall rapidly after 1995 was subjected to strong opposition. As the proposers of this theory were themselves not too sure about it, the theory was easily discarded. With this assurance from the authorities on the subject, real estate continued to be increasingly over-valued. Coupled with this was the carelessness in the lending standards. Even the most risky assets were securitized at the high value of houses prevailing at that time. And, the increase in rate of interest of mortgage loans proved to be the final move. Due to increased mortgage payments, there was a rise in the number of NPAs. Thus, houses became a less lucrative option for investment. Sales and valuation of houses decreased and the situation became such that even if the houses were sold, the loaned amount could not be recovered. The negative wealth effect came into play. As the commercial banks associated with the mortgage market attempted to bail out these mortgage institutions by capital injections, they also went bankrupt, too. This was, again, due to the waning confidence of the customers who were withdrawing their money. The ultimate result was the collapse of each and every financial institution connected to the mortgage market and in addition, it also affected the real sector. Policy Recommendations There are a few policy recommendations that can lift the US economy and others out of this financial crisis. The adverse shock suffered due to the complete shattering of the financial backbone of the economy had had fatal effects on growth of the real sector by a rapid decrease in employment and output rates. With time the impact of this fiasco as well as the interactions between the financial and the real sectors is intensifying. In order to steer the economy out of impending problems, effective monetary and fiscal policy has to be implemented. (OECD, 2008, p.11) It must be realized that injecting capital into the financial system is not the solution to the problem. Capital injections must be given to the real sector by investing in public undertakings that will provide more employment and increase the output of the economy, thus, tackling the problem of a low rate of growth. The FHA and GSE are government mortgage loans that became less popular after the advent of the sub-prime mortgage market. However, these are extremely well monitored and thus, have relatively lower levels of NPAs. In order to tackle the problem of information asymmetry in the mortgage market, the provision for standardized FHA loans should be made that can be compared to subprime loans. Furthermore, it should be made mandatory for the lenders to disclose details about high risk ventures. (Lucas, 2010, p.128) Conclusion It may be concluded that even though the magnitude and extent of effects of the collapse of the US mortgage market on the real sector and the economy of other countries is vast, its detrimental effects can be reversed by the use of adequate policies and massive public investment for output and employment generation. References Baumol, W.J. and A.S. Blinder (2010), Economics: Principles and Policy. USA: South-Western Cengage Learning. Global Economic Crisis Research Centre (2010). Global Economic Crisis: Impact on Finance. USA: South-Western Cengage Learning. Kim, S. (2010). International Banking in the New Era: Post Crisis Challenges and Opportunities. UK: Emerald Group Publishing Ltd. Lucas, D (2010). Measuring and Managing Federal Financial Risk. London: University of Chicago Press Ltd. Muller, A. (2010). Financial Crisis: Impacts and Reactions. Germany: GRIN Verlag. OECD (2008). OECD Economic Surveys. US: OECD Publications. UN: Economic Commission for Europe (2010). Forest Products Annual Market Review 2009- 10. USA: United Nations Publications. Watcher, S.M. & S.M. Smith (2011), The American Mortgage System: Crisis and Reform. USA: University of Pennsylvania Press. Read More