The USA Mortgage Crisis Scenario - Case Study Example

Housing Prices Introduction: The basic purpose of this paper is to try and understand the shift in the price of housing over the last 10 years. It is a generally accepted notion that housing pricing have perhaps been the most volatile of any commodity over the last few years and the recent sub-prime mortgage crisis in the U.S. has finally dawned this fact upon us that housing prices are no longer the stable base which they were once perceived to be. The current global recession which is being suffered be the economies all around the world has to be attributed to the extremely volatile housing market, even though the rather callous and risk sensitive attitude of investors has not helped matters much. In this paper, we will first have a look at the whole U.S. mortgage crisis scenario as that has been the major factor that has brought this whole situation into the public perception. Understanding the situation in the light of statistics is very important, as even though this whole topic is so dense and enormous that it cannot be in this paper, but it is certainly essential to have a feel of the situation before we move along. Then, we would move onto the U.S. housing market and try to understand the shifts in pricing over the past decade and the reasons behind these shifts. Furthermore, we will try and determine the implications of the housing market on the economy of the country in general i.e. what effect will the volatility have on the demand and supply equilibrium of the market itself and the greater effect this will have on the economy in general. This is an important section of this paper as this provides the rationale for conducting an analysis on the housing prices and also helps us understand key economic indicators which can help us understand the market better and perhaps prevent market meltdowns like the one suffered in 2006 from occurring again. Finally, we will conclude the paper with our final remarks on the conducted analysis. [1] U.S. Mortgage Crisis: The U.S. mortgage side has been ruined. Investment and mortgage bankers have made billions. Wall Street recovered $27 billion in revenue by selling and trading asset-backed securities. Many middle-class families saw the prices of their homes rise and felt prosperous. Even those from lower classes "benefited" from this housing price bubble by being able to own houses with small down payments. Rising prices of housing led to increased borrowing on home equity. The Americans were enjoying their time in the U.S as housing prices shot up 40% between 2000 and 2006 to a high of $234,000. The ratio of median house price to median household income rose from a historically steady ratio of three times (from 1970- 2000) to five times in 2006. This could not be sustained. Housing prices tapered off and started to decline in early 2006 and furthermore in 2007 and 2008; in compliance with what we have seen in the recent two years. With a $20 trillion housing sector, every 10% fall erodes off $2 trillion in household wealth. Almost in parallel, rates of default and foreclosure began to climb. In 2006, 1.2 million household lends saw foreclosure, up 42% from the previous year. The basic definition of sub-prime mortgages is basically lending to borrowers who want to buy a house but who have a weak credit rating. Lenders did so by providing small or zero down payment, and low introductory adjustable rate mortgages. Between 2004 and 2006, there were bookings of $1.5 trillion (15% of the total U.S. housing lends) of sub-prime mortgages. Total sub-prime lends form 25% of the housing mortgage market; these sub-prime lends were fine as long as the housing market continued to boom and interest rates remained stable. When these conditions disappeared, sub-prime borrowers defaulted. The defaults caused an implosion of Mortgage-backed securities and the Collateralized debt duties industry. The blow out shelled in June 2007 with the collapse of sub-prime mortgage hedge funds managed by Bear Stearns, quickly followed by suspending other funds managed by BNP Paribas. [2] Housing Sector: Decrease in housing demand and increase in inventories have caused home prices to take a significant downward trend. As reported by the National Association of Realtors, the U.S. median home price was $210,200 in November 2007, decreased 3.3% from the similar period in 2006. The current large housing inventory overhang (10.3 months of inventory at the current sales pace) will force further price corrections. Also, with the speculators in the market, the price decline will become more severe as expected falling home prices will substantially lessen purchases by this class of buyers. A record number of ARMs will most likely take place in end of 2008. Many of the lends, will go delinquent as borrowers will find problems in making payments and would be unable to refinance because house demand along with the housing price declining shall lead the borrowers to have a liability that would be more than what their homes are worth. Sub-prime borrowers were able to convert their mortgage into another sub-prime lends and avoids the payment reset until very recently. Most sub-prime lending over the last couple of years was of the variety where, it is fixed for 2 years and then adjusted every six months after that. But in 2005, sub-prime borrowers in a difficult position facing payment resets, shall be in a tight position to refinance the mortgage because of tighter standards on underwriting and declining housing prices. For several little down payment borrowers, the decline in housing prices has more than reduced their investment in housing and lead their sub-prime lends in to face delinquency. Two-pronged effects are estimated of declining credit quality on the market for housing and market prices in the future. Firstly, increased foreclosures would increase the supply of houses by an expected value of 0.5 million units each year. [3] Already the market is in excess supply, more foreclosures will put further downward stress on market housing prices. Hence, lower prices shall aggravate problem of the credit squeeze in credit markets and create more problems for borrowers who wish to refinance their mortgage that is nearing reset. This cycle of borrowers facing foreclosures is whereby the credit crisis has begun to multiply problems all by itself and will fail to arrest this downward spiral of the housing market on its own unless government intervention takes place. Second, tougher standards for credit shall make it difficult for home purchasers to buy homes, hence leading to reduction in demand for homes and leading to further decrease in home prices. Federal Reserve surveys say that lending officers found more number of banks that toughened mortgage lending standards during 2007 compared to other years since 1990s. Apart from that, lend terms being tougher in terms of higher interest rates and down payments will leave less liquidity with what the buyers would need to spend on newer homes. The credit quality mortgage market is also taken a declining course. The default rate for ARMs to borrowers went up to 5% in the 4th quarter in 2007, from 3.1% in the same period a year before and the maximum rate in 4 years, according to the Mortgage Bankers Association. The national average default on sub-prime lending is over 16%, while 3.1% of prime mortgage lends are in default. Overall we expect the mortgage default rates to peak at more than 5% over the next few years. [4] Economy and the Housing Scenario: The hold up of the housing industry has adversely affected the overall performance of the economy. The sharp decline in the demand for houses and the simultaneous jump in the prices of home supplies have left the entire sector in recession. House building projects halved over the past three years, according to statistics provided by the Commerce department and the purchases of new house also almost halved; 47% to be exact. This contrived in escalating the demand for home supplies which went over 500,000 units. This change cut out 1.2% of the growth in GDP in the fourth quarter of 2007 which was again witnessed in 2008. However, the effects of the change in the housing markets were not just limited to its own sector. Swelling prices of houses since 2003 contrived in producing large capital gains for home and/or property owners, which contributed toward the creation of an immense wealth effect which immensely decreased the national savings rate. [5] Dating back to 2003, the average annual growth in the real spending of consumers was measured to be at a glaring 3.2%. This time also saw the escalation of consumer durable spending i.e. home supplies etc to a 5.7% annual growth rate. As population's consumption contributes to about 71% of the overall economy of the country, the growing valuation of housing as a key mechanism for the overall growth the economy was enjoying at that point in time. This growing valuation was also the key contributor to the fact that the household's savings rate over the two years 2005-2007 was almost negative. This had been due to the fact that most households have removed equity from their housing properties in order to finance other activities of their choice. It was expected in 1007 that economic growth could slow down to 1% in 1008 after being at 2.5% in 2007 due to the decreased consumer spending light of the bursting of the housing bubble and the country would go into a recession. Even thought, many calamities in the financial sector have been witnessed, this stage has not been reached as yet, however; it still remains a strong possibility for the economy. [6] Conclusion: We have seen the implications of the housing market on the U.S. economy and it would not be much of an overstatement if we were to rationalize that the current global recession has been a child of the housing market crisis; such has been the important of the housing industry on the economy. Housing prices nearly tripled and then completely capitulated in the past decade; this has been a huge issue for the governments around the world as they didn't have the ability to control the private banks who 'bet' against the market and dug an even deeper hole for the economy then what would have happened in the normal circumstances. On a final note, all that can be said is that housing is a factor which will remain consistent across all economies and across all manners of social reforms, therefore, governments around the would have to consider the extreme volatility of this market and try to determine mechanism to control, if not completely curb, this volatility in prices. Bibliography: 1. Farzad, Roben. 2007. "Let the Blame Begin." Business Week 4045: 32-35. 2. Leonhardt, David. 2007. "Soft Landing Unlikely for the Housing Slump." International Herald Tribune, September 20. 3. Papadimitriou, Dimitri, Edward Chilcote, and Gennaro Zezza. 2006. "Are Housing Prices, Household Debt, and Growth Sustainable" Strategic Analysis, January. Annandale-on-Hudson, NY: The Levy Economics Institute of Bard College. 4. Gupta, R., and Miller S. M. 2009 "Ripple Effects" and Forecasting Home Prices in Los Angeles, Las Vegas, and Phoenix." University of Nevada, Las Vegas Working Paper No. 0902. 5. Kuethe, T. H., and Pede, V., 2008. Regional housing Price Cycles: A Spatio-Temporal Analysis Using US State Level Data. Working Paper #08-14, Department of Agricultural Economics, Purdue University. 6. Meen, G. P. (1990). The Removal of Mortgage Market Constraints and the Implications for Econometric Modelling of UK House Prices. Oxford Bulletin of Economics and Statistics, Vol. 52, 1-24 Read More