Understanding the Current Mortgage Crisis - Coursework Example

Understanding the Current Mortgage Crisis The present condition of the US mortgage industry has been described by the United s Conference of Mayors (USCM) as “a dramatic real estate bubble — the inflation of both home values far excess of historic norms of reasonable estimates of the growth of fundamental determinants of home value (2007).” Most analysts call it subprime mortgage crisis, which is “an ongoing economic problem manifesting itself through liquidity issues in the global banking system owing to foreclosures (Wikipedia, 2008). While, Eric Janszen of iTulip, Inc. termed it ‘asset-price hyperinflation’ – the huge spike in asset prices that results from a perverse self-reinforcing belief system, a fog that clouds judgment of all but the most aware participants in the market (2008).” Obviously, whichever of this term indicates speculative investment. Whatever this phenomenon is called, the problem it has created is really huge that it has caused serious damage extending from local to global economy with its negative impact felt by all sectors – the hardest hit of which is the financial-banking institutions, which in the final analysis have brought this impasse on themselves after gaining so much from the economic growth. Crisis Impact Headlines all over the world, especially among rich countries, illustrate the breadth of damage this crisis caused – “More Lenders Falter,” “American Home Mortgage Falls as Credit Markets Tighten,” “Is Countrywide the Next to Crash and Burn? (Lending Clarity, 2007),” “Foreclosures soar, layoffs mount in US mortgage industry crisis (Kay, 2007),” “Stressed Home Owners: Is There a Bailout in the Works? (Ibid.),” “Subprime crisis continues to impact financial institutions around the world (Strategic Risk, 2007),” “Treasury Acts to Shore Up Fannie Mae and Freddie Mac (Labataon, 2008),” “Woes Afflicting Mortgage Giants Raise Loan Rates (Bajaj, 2008),” “2.2 million vacant homes for sale (Luhby, 2008),” “Housing Report Leads to Sharp Fall in Stocks (Grynbaum, 2008),” “Banks brace for more pain (Ellis, 2008),” – showing one grim picture of reality – that the haven of paradise promised by “housing bulls (Tully, 2006)” has exploded like “balloons pumped up with too much hot air (Ibid)” leaving an “estimate loss of home price wealth at between $2 trillion and $4 trillion in the wake of the collapse of the subprime mortgage market (Cohan, 2007).” In its report, the USCM clearly explained the chain effect of the economic impact of the recent mortgage credit crisis in 2008 which can be summarized as follows: 1. The continuing decline in home sales and in new home building beginning in 2007 will result to a $166 billion lower GDP because new residential investment will be weaker, lowering spending and income across the construction industries, and because consumer spending is reduced as homeowners respond to decreased home equity wealth. Both of these spending impacts have multiplier effects across the economy as lower incomes decrease demand for other goods and services resulting to 524, 000 fewer jobs across the country. 2. The initial adjustment of over-heated home prices combined with a weaker market demand and large inventories of homes for sale would have reduced by $676 billion devaluing properties by $1.2 trillion. 3. Foreclosures will increase by at least 1.4 million valued at $316 billion resulting to a significant risk of downward pressure on taxable value which would mean lesser government revenue. This negative revenue sourcing will consequently be compounded by weaker sales tax due to declines in construction-related purchases and new furniture and fixtures spending usually coincident with home purchases, due to dearth of spending financed by home equity lines of credit, and due to the pullback in general consumption by households. Crisis Mitigation The above economic indicators reveal an increased risk of recession that different authorities consider various ways to protect borrowers from the effects of their loan payments to ameliorate the crisis impact. Federal and local governments together with financial-banking institutions are working together finding steps to ease the impact of the crisis. One of which is the mortgage loan modification to avoid foreclosures because as David Kittle, chairman elect of the Mortgage Bankers Association said, “Foreclosure is a lengthy and extremely costly process for the industry and generally, a losing financial proposition. Several independent studies have found the losses to be quite significant over $50,000 per foreclosed home or as much as 30 to 60 percent of the outstanding loan balance (Christie, 2008).” The House Financial Services Committee urged home lenders, loan servicers and housing advocates to work out affordable loans to reduce foreclosures and ease the crisis impact on troubled homeowners. In response, “Bank of America’s Gross said that the bank will modify and work out at least $40 billion in mortgages by the end of 2009, helping about 250,000 troubled homeowners (Christie, 2008).” Banks’ capitalization is also strengthened. The government helped banks strengthen their capitalization by cutting rates rabidly. “With short-term interest rates holding steady at 2%, large cap banks were able to make more money from taking in deposits and lending them back out (Ellis, 2008).” The boldest of all ways is the government’s rescue of insolvent financial-banking institutions costing the Federal Reserves billions of dollars that could have been used for social services. On February 13, 2008, President George W. Bush signed into law the Economic Stimulus Act of 2008, to cushion the negative impact of the crisis in the form of tax rebates, tax and an increase in the limits imposed on mortgages eligible for purchase by government-sponsored enterprises (GSEs). This bill totals $152 billion for 2008 plus $124 billion over the next ten years, a sum total of $276 billion. (Wikipedia, 2008) When Bear Stearns, one of the major financial institutions in America, was going into bankruptcy, the Federal government dramatically intervened and rescued it to preempt the shock it can possibly cause to the financial system at home and around the globe. But little had this effected the market. The crisis worsens, now, hitting the main players in the financing industry. Federal National Mortgage Association (Fannie Mae), the nation’s largest mortgage buyer and a financial juggernaut that affects the lives of ten millions of home buyers and which was created during the Depression to make sure that sufficient funds were available to mortgage lenders, then rechartered by Congress in 1968 as a publicly traded company, and Federal Home Loan Mortgage Corporation (Freddie Mac), a publicly traded company that operates under a federal charter, and the nation’s second largest mortgage buyer have reported steep losses as the housing market has soured. (NYT, 2008) The government is compelled to take bolder steps to calm down the market, but at the same time careful not to incite or heighten anti-financial institution sentiments, especially so that the culpability to this recent economic crisis is pointed by many analysts and economists at financial institutions. On July 14, 2008, The New York Times reported that “alarmed by the sharply eroding confidence in the nation’s two largest mortgage finance companies, the Bush administration on Sunday asked congress to approve a sweeping rescue package that would give officials the power to inject billions of federal dollars into the beleaguered companies through investment and loans.” (Labaton, 2008) Although it is understandable that due to their size, and key role in the US housing market, the US government has to bolster the two leading mortgage companies, Fannie Mae and Freddie Mac, “the inevitable debate about the ‘moral hazard’ of keeping the dirty bath water to save the baby remains nagging (Lending Clarity, 2007).” Crisis Analysis Economic practices and policies are generally need-driven. And all existing institutions operate not in a vacuum but in a given socio-economic-political context. Therefore, to understand the root of this crisis, it would be helpful to remember that “the market we are watching today is a by product of the market six years ago (Barnes, 2007). It is noteworthy to rewind back to late 2001, when the horrible and unprecedented bombing of the World Trade Center created global terror, and shook an already-struggling economy, which was just beginning to come out of the recession brought about by the tech bubble of late 1990s. Guided by Keyne’s doctrine: “When a business cycle peaks and starts its downward slide, one must increase federal spending, cut taxes, and lower short-term interest rates to increase the money supply and expand credit (Janszen, 2008),” the Federal government began cutting rates dramatically down to 1% in 2003 (Op. cit.) to jumpstart the sluggish market. This bold measure aims to expand money supply and encourage borrowing in order to spur spending and investing, thereby promoting the culture of consumerism. Past events showed that this federal policy measure indeed worked. The economy began to steadily progress in 2002. Real estate begins to look attractive as the financial institutions lure even subprime homebuyers to avail subprime mortgages. Many were lured, even those who expectantly would default. This created a dramatic increase in real estate revenues, which also caused growth in other related economic activities, creating the ability to borrow more. “The ability to borrow more prompted banks and other large investors to create collateralized debt obligation (CDO), which essentially scooped up equity and “mezzanine” (medium-to-low rated) tranches from MBSs and repackaged them yet again, this time into mezzanine CDOs (Op. cit.).” With CDOs, “millions of Americans with poor credit histories who might not otherwise have bought their homes were granted subprime mortgages (Treanor, 2008).” “The CDO market (secured mainly with subprime debt) ballooned to more than $600 billion in issuance during 2006 alone – more than 10-times the amount issued just a decade earlier. These securities, although illiquid, were picked up eagerly in the secondary markets, which happily parked them into large institutional funds at their market-beating interest rates (Op. cit.),” until they began to blow up last year creating pandemonium at banks and brokers on Wall Street. Treanor in his paper illustrated that the villain of this market turmoil is no other than the CDO, which one investment banker recently described to him as ‘the most toxic element of the financial markets today’ (2008). Analysis of the recent crisis – its nature, cause, impact, and the measures being taken both by the government and the financial-banking sector, would lead us to understand that the crisis that had taken place was in fact a result of the spiraling growth of the economy in 2002 brought about by subprime mortgage and collateral debt obligations – the very creations of the financial-banking industry. Furthermore, these two drivers of 2000 growth are in fact the same causes of the crisis havocking our economy today. Thus it is not surprising to see that the most badly whacked by this crisis are these financial institutions that propagated the myths of the real estate bubble, because it was they that gained the most. Understanding this phenomenon in a wider context will bring us to a closer look at the country’s economic system. With finance, insurance, and real estate – FIRE as the main propellers now in the U.S. economy since 1975 instead of the high-value, finished-goods-producing industries as steel and automobiles (Janszen, 2008), and as had also been demonstrated by the tech bubble in late 1990s, it should have been expected that the recent real estate growth would ultimately reach its peak and burst. If only this has been foreseen on time, the inevitable crisis could have been preempted, at best or its impact could have been cushioned, at the least. What everybody is doing today is to mitigate the damage that could possibly be worse than what it has been today. And this is the best thing to be done at the moment. Since these measures are only mitigating measures, it should be understood that inherent in them are the same problems that they are trying to solve, because later on they will also reach their limit. For instance, the Federal reserves cannot continue bailing out every falling financial institution especially so that almost everybody today needs assistance. Sooner or later, the reserve will deplete, and this will be very bad to the economy. What the government should think about is the creation of more stable jobs to give the public the needed purchasing power to prime up the slugging economy. Also, many question the wisdom of the government bailing out financial companies who gained and later caused this crisis while homeowners bleed to death paying high interest rates. On the other hand, for financial institutions to modify mortgage loans, they needed bigger capitalization, thus if they are not bailed out, and they become insolvent, the more the economy will recede. Although the study on the cost and benefit of modification by Mason stated that “Modification will not be suited to helping avoid the massive defaults expected as a result of ARM interest rate resets…Legislative pushes to mis-apply the practice to those ends will substantially worsen industry performance (2007).” Conclusion The mortgage crisis today is essentially similar with the 1990 crisis. Both are characterized by a financial crisis that is a result of big investments that are based only on mere speculations. Therefore, financial-banking institutions should have not been caught by this crisis, if only they were not driven by too much greed. In other words, with FIRE, “a credit-finance, asset-price-inflation machine organized around one tenet: that the value of one’s asset, which used to fluctuate in response to the business cycle and financial markets, now goes in only one direction, up, with no more than occasional short-term reversals (Janszen, 2007),” as the prime movers now of our economy, what is needed then is another bubble creation. With this premise, US growth will always be short-term, and worst there might come a time that even bubbles will be exhausted. Although the immediate need today is mitigating the crisis impact, it is also high time that once more, economists and policy makers, setting aside their vested interest, sit together to sincerely study the country’s economic system, to which the global economic system is entangled. Lessons are really learned the hard way; but what is important is that we really truly learned from this crisis. If not, then let us wait for another more serious crisis, as we try to search for the next big thing to prime up our economy, and be out of this crisis. Reference List Bajaj, Vikas. (2008, July 23). Woes afflicting mortgage giants raise loan rates. The New York Times. Retrieved from http://www.nytimes.com/2008/07/23/business/23rates.html?ei=5087&em=&en=d14f44f47dca58af&ex=1217044800&pagewanted=all Barnes, Ryan. (2007). The fuel that fed the subprime meltdown. Retrieved from http://www.investopedia.com/articles/07/subprimie-overview.asp?viewall=1-7 Christie, Les. (2008, July 17). A plan to jumpstart the mortgage market. CNNMoney.com. Retrieved from http://money.cnn.com/2008/07/17/real_estate/jumpstarting_mortgage/index.htm (2008, July 25). Foreclosure filings up 120%. CNNMoney.com. Retrieved from http://money.cnn.com/2008/07/25/real_estate/foreclosure_figures_up_again/index.htm Mortgage industry grilled in Washington. CNNMoney.com. 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