The Housing Bubble in the United Kingdom - Case Study Example

Running Head: essay Economics of the of the of the Introduction Much has been talked and analyzed about the economic turmoil of 2007. From demand supply mismatch to banks’ irresponsible behavior, several reasons accumulated into this once-in-a-century recession. This paper attempts to discuss the demand supply analysis of the housing bubble which was the prime reason behind this crisis. High degree of reliance over the financial instruments such as securitization played a crucial role in further aggravation of the crisis which will also form part of this discussion. Paper will also include a discussion over the role of credit rating agencies responsible for the global financial crisis. Also, discussion regarding the changes in the United Kingdom monetary and fiscal policy follows the housing bubble. Part 1- Housing Bubble: Demand and Supply Analysis The economic crisis of 2007 was attributed to faulty monetary and fiscal policy where housing bubble also contributed a lot. It arose from the ignorance of banks towards regulations and surpassing their credit availability limits. A demand and supply analysis of the tremendous changes in the house prices over the last three years is done to clear the picture. Before analyzing the price bubble, it is first essential to note down the definitions of housing demand and supply. Housing demand emerges when new households are created which can be the case of families separating, children moving out for separate homes or roommates start living apart in individual homes. This creates new households demanding more houses. Likewise, housing supply is a function of new home constructions or mainly home foreclosures. However, if the leaving homeowner moves to a new home, it itself creates new demand rather than supply (Durden 2010). Housing demand aspects- Last three years witnessed a steep decline in the number of new households. This decline was a result of high unemployment, tight credit policy of banks and slow growth in the salaries and wages of people (Wheaton & Nechayev 2006). Housing supply aspects- The decline in housing demand urged the construction of houses to pause down but return of foreclosed homes back for sale and continuing constructions led to enormous excess of housing supply over its demand which could not set off the prices. Hence not only the buyers but also the real estate developers as well as dealers got caught in the vicious cycle of credit default. Contribution of banks Banks played an important role in mismatching the demand supply function of housing prices. Banks presented illusionary house stocks which prompted households to borrow more than what their earnings allowed. Credit history and capability to repay the loans were not assessed or analyzed and households were provided home loans at higher rates of interest due to anticipation of high housing supply at that time (Fig 1 & 2). However, the home loans soon exceeded the supply and thus increased housing demand led to an instant shoot up in the house prices (United Kingdom: Selected Issues 2003). The demon of subprime crisis was invited by the banks and financial institutions (FIs) where they overtly relied on securitization (i.e. a financial instrument used to mitigate risk which enables direct lending to borrowers by the investors without the requirement of banks acting as the intermediaries), using it to pool the variety of loans as marketable assets which would be sold readily and in that manner passing the subprime loans to the other banks or FIs. Securitization emerged as a strong tool in the later part of the last century with the finance experts trying their hands on derivatives, futures and options. More or less this technique has worked quite well for all the banks but with bad and risky loans at the bottom of the pool, the foundations of credit risk management were shaken. Banks mired with the liquidity crunch after the worsening of crisis started looking towards the government for meeting out their liquid capital requirements, but simultaneously they distanced themselves from advances business. This reluctance detained them from the possible recovery that was so badly needed. Another alarming issue was the role of the credit rating agency and their modus operandi. Their credit rating policies formed the root of the problem as most of their methods were outdated and were easily manoeuvred. Fig. 1 Predictions As obvious from Figure 3, the housing inventory exceeds the housing demand and will require around 10-12 months more to balance the demand and supply of houses (Fig 3). On the other hand, some housing mortgages will be in their last stages of delinquencies and turning into foreclosures which will exceed the supply (Fig 4). Thus, it will take around 3-4 years more to balance the housing supply with the appreciated demand. House prices will edge a bit lower but shoot up again in the years to come. Fig. 2 Fig. 3 Fig. 4 Part 2- Changes in the UK Fiscal and Monetary Policy Theoretically, monetary policy is aimed at managing the supply of money while fiscal policy focuses on determining the appropriate levels of government spending and earning revenues through taxes. However, since the 2007 downturn, questions have been put on government’s ability to find an optimum mix of monetary and fiscal policy and recover the economy. One prime reason behind changes in the policies is the inflationary trend and widespread and tectonic shifts in the oil and commodity prices. Due to steep price rise, money also grew and so does the pressure on economy to supply the commodities and balance the demand. In the financial markets, financial assets pricing have seen tremendous changes which has infused uncertainty among investors. The financial crisis slowed down the economy and increased unemployment and high consumer lending. However, strong federal spending continued to sustain the situation and provide boost to the economy. At the moment of subprime crisis, Federal funds were liquidated and rates were lowered down to provide money injection to financial institutions. In the period of last three years, the monetary and fiscal policy has been aggressive due to the falling of money holding capacity by banks and other financial institutions. The central bank also could not perform its role as expected and the need to react quickly and make decisions, monetary and fiscal policy was made accommodative (King 2005). At the time of crisis, monetary policy was loosened and rates were almost slashed to zero while fiscal policy was used to increase the government spending to match the private and public demand. As a result, bank of England started buying assets from the private sector and infusing money supply in the economy (The Crisis of 2007-2010 n.d) (Fig. 5). Fig. 5 However, expansionary monetary and fiscal policy also led to inflation and increased government debt. Due to increased government spending, debt is mounting up across other markets and economies (Fig. 6). Fig. 6 Conclusion After having discussed the reasons behind housing bubble and shifts in the monetary and fiscal policy, it is pretty much clear that the policies have to become more stringent and less accommodative in the coming years. This is important to place regulations on banks’ functioning and also avoid chances of another housing bubble in the future. Also, a comprehensive framework has to be implemented in place for increasing the financial stability; anchoring the role of central banks and making commercial banks realize their limits and responsibilities. But as far as banks are concerned we have seen that despite of highly structured framework for regulatory supervision such as BASEL II (Allen & Saunders 2010, p. 18), the deficiencies in the system were too many which did not help the cause at all. However few large banks still managed to sight the problem just in time and took initiative to counter the expected danger. So a detailed scrutiny of whatever framework that is being used is extremely important to be done on periodic basis. Emerging financial domains and related financial institutions yet pose another challenge for the policymakers. Alongside balanced yet tighter monetary and fiscal policies, each and every economy now requires such a robust framework that would keep check on the deviations that creep into the lending system and procedure of the banks and FIs. Financial instruments that are available in the market for managing risk through hedging and similar strategies are to be used wisely and sole reliance over a single method is an open invitation to problems and defaults. Credit Rating agencies cannot be ignored and they have been equally responsible for the turmoil. Timely updating and standardizing the credit rating methods is the primary requirement without which an opportunity for another dangerous bubble formation would be just a matter of time. References Allen, L & Saunders, A. (2010). Credit Risk Management in and out of the Financial Crisis: new approaches to value and risk and other paradigms. 3rd Ed. New Jersey: John Wiley & Sons Durden, T. (2010). Supply and Demand: A Detailed analysis at projected home prices. Retrieved 28 Nov, 2010 from http://www.greenfaucet.com/economy/supply-and-demand-a-detailed-analysis-at-projected-home-prices/06824 King, M. (2005). Monetary Policy Developments. Retrieved 28 Nov, 2010 from http://www.bis.org/review/r050128a.pdf The Crisis of 2007-2010 n.d. Retrieved 28 Nov, 2010 from http://miha.ef.uni-lj.si/_dokumenti3plus2/193000/BE-1__blanchard_et_al_pp20_.pdf United Kingdom: Selected Issues 2003. International Monetary Fund. Wheaton, W.C & Nechayev, G. (2006). Past Housing Cycles and the Current Housing Boom: What’s different this time? Retrieved 28 Nov, 2010 from http://nowandfutures.com/download/housingcycles.pdf Read More