The US Housing Market Analysis - Term Paper Example

Macroeconomics Term paper Table of Content Table of Content 2 Introduction 3 Analysis 3 Imprudent lending 4 Interest rate manipulation 6 Change in SEC Rule 7 Debt to Income ratio 7 Unemployment 8 Fall in Demand 9 Conclusion 10 References 11 Appendix 12 Introduction The prevailing economic slowdown in US and the world has emanated from the subprime mortgage crisis in the US. In the US, the subprime crisis got started due to the imprudent lenders, mainly the subprime lenders disbursing loans to entities or individuals who were undeserving of loans and had low ratings in terms of credit worthiness. This was being done in hope that the US housing prices would go up always but when to the contrary they started falling, the whole economic environment got massively affected and finally the US economy plunged deep into recession taking along with it major parts of the world economy. Analysis The housing market like any other market follows the basic supply and demand laws. Demand means the amount of good consumers demand at a certain price. While supple means the amount of goods the suppliers/ produces are willing to supply at a certain price. Generally when there is a price rise, demand falls and where as supply increases when there is higher price (supply and demand, 2008). But incase of the US housing market there was almost abnormal rise in the prices and then a sudden fall ushered in from 2006 onwards. This was preceded by a stable housing price environment in most parts of the 1990s while an increasing trend was witnessed towards the end of the 1990s. Housing prices rose by a whopping 87% during the period January 2002 to June 2006. While the sudden decline started in 2006 and gathered enormous proportions in the years 2007, 2008 and is still continuing. Housing prices were down by roughly 25% in 2008 third financial quarter in comparison to the peak levels of 2006. Fig.1. Housing Price Index Source: Gwartney, et al. This fall in housing prices brought with it drastic fall in the valuations of the subprime mortgages which were held by numerous financial institutions. But to understand the present crisis the beginning stages of it would have to be delved into. These are: Imprudent lending During the middle part of the 1990s governmental regulations in relation to lending norms were relaxed drastically and ensuing regulations followed which made it mandatory for housing loan institution like Fannie Mae and Freddie Mac to increase their share of US mortgages belonging to middle as well as low income families by significant levels. During the era 1999 US federal rules also made it sure that these two institutions which hold a major portion of the US mortgages accepted greater amount of loans but with minimal and in many cases, absolutely no down payment. Almost a similar kind of regulation was passed in the year 1995 in context f bank's landings through which they were made to lend heavily to minority sections of the population in the vicinity of the banks in the process prudent lending mechanisms and evaluation of credit worthiness were overlooked. This was the 'Community Reinvestment Act'. Testimony to the afore mentioned fact Fannie Mae and Freddie Mac's overall share of mortgages under their holding went up to 45% in the year 2001 from only 25% in the year 1990. This fact is shown in Fig.2. It is also evident from the figure that how these two institution's share of the outstanding mortgages went up continuously throughout the 1990s and also almost through the 2000s. Fig.2. Outstanding Mortgages and Fannie Mae and Freddie Mac's share of them. Source: Gwartney, et al. Interest rate manipulation During the period between 2002 and 2006 the US Fed ushered in an extended low interest rate phase. As a result of the ensuing low rate scenario there was a huge demand for the houses and consecutively the prices also soared in the sector. Fig.3. 1-Year Treasury Bill Rate & Fed Fund Rate Source: Gwartney, et al. Fig.3. shows that how the fed had kept the interest rate for the short term very low at less than 2% levels during the period between 2002 and 2004. This policy of the US fed resulted in making the Adjustable Rate Loans enormously attractive to the borrowers who also found the very low down payment policy of these loans very attractive. But beginning 2005 and throughout 2006 the US Fed changed these adjustable rates as a result of which the monthly installment payments on these loans for the borrowers increased hugely. Following this the default rate also started growing rapidly and the housing market saw a rapid decline in valuations and prices. Demand for houses came down. By December 2008 the country saw the highest fall in sale in context of single family houses. Consecutively resale prices also went down massively in fact they just collapsed and experts compared it to the era of the great depression. This drop in sales was the maximum for the last two decades (Willis B., December 2008). Change in SEC Rule In the month of April, 2004 a change was done to the existing SEC Rule. This change was such that lending practices by financial institutions and especially investments banks became lax and there was a huge increase in high-leveraged lending by them. These also saw an equally abrupt and fast downfall the default interest rates were increased. This change in rule acted as an impetus towards lending for residential housing on a favored basis. This also resulted in increased leveraging of these residential loans to the extent of 60:1 when these loans were combined together and the financing was done by underlying securities. But with the increase of default rates (aforementioned) the investments banks which were highly leveraged crumbled Willis, (The Economic Crisis, n.d.). Debt to Income ratio Debt to income ratio has been on the higher side in the US economy for a long period of time. This is evident form the fact that during many decades preceding 1980s, it was at the range of 45% to 60%. But this debt to income ration rose to a whopping 135% by the year 2007. During the same period the interest rates on various kinds of household debts also went up significantly. In order to leverage the fact that the housing loan interest was tax deductable, the borrowing public put in more of their debt into the housing loan basket. Due to this overburdened position in terms of housing loans when the interest rates went up, the sudden rise in monthly payments caught them unaware default rates went up briskly. Demand for housing fell, their valuations came down and the whole market condition deteriorated abruptly Willis, (The Economic Crisis, n.d.). Fig.4. Debt/Disposable Income Ratio Source: Gwartney, Macpherson, Sobel, and Stroup. The Economic Crisis. Figure. 4 show the continued rise of the debt to income ratio from as far back as 1953 to 2008. During the year 2000, it crossed the crucial level of 100% and jumped to 135% by the year 2008 Willis, (The Economic Crisis, n.d.). Unemployment Fig.5. April 2007 to April 2009 Source: The Unemployment Situation, 2009. The present subprime crisis and the following economic crisis has resulted in huge unemployment rates across the country which is evident from the above figure. It shows how the unemployment rate has reached almost 10% levels by April 2009 while it was roughly at around 4.5% even in April 2007. This high rate of unemployment is also going to have huge negative effects on the economy and demand for various good as well as the housing sector is also going to and has come down. Fall in Demand All these factors have led to the economic crisis and the fall in demand and falling prices in the housing sector especially from 2005 to the present day. Fig.5. Falling Housing Prices Source: Miller D. The above figure shows how the housing prices in the US have started rising abruptly from 2000-2001 onwards and how the trend had continued till 2005 and then again came down equally abruptly then onwards. Conclusion As mentioned above various factors have all led to the rise in demand for the housing sector and its consecutive rise in prices. Due to laxity in lending norms lending for the housing sector was increased but when the interest rates went up suddenly, the borrowers were caught unaware and default rates rose. As a result the housing prices fell which again resulted in fall in value of the securities whose underlying asset was housing prices. Over all the economy got hit and people started loosing jobs and unemployment rose resulting in fall in demand for the housing sector. References Supply and Demand, (2008), The Columbia Encyclopedia, Sixth Edition, Encyclopedia.com. Retrieved May 29, 2009, from . Gwartney, Macpherson D., Sobel and Stroup R., (No Date), The Economic Crisis 2008: Cause and Aftermath, College of Business and Economics, Western Washington University, Retrieved May 29, 2009, from . Willis B., (December 2008), U.S. Economy: Home Prices Fall Near Depression Pace (Update1), Retrieved May 29, 2009, from . Miller D., (No Date), U.S. Housing Market Forecast: No Gain, More Pain, Retrieved May 29, 2009, from . The Unemployment Situation, (2009), News. Bureau of Labor Statistics, Retrieved May 29, 2009, from . Appendix Fig.1. Housing Price Index. Pg.4 Fig.2. Outstanding Mortgages and Fannie Mae and Freddie Mac's share of them. Pg.5 Fig.3. 1-Year Treasury Bill Rate & Fed Fund Rate. Pg.6 Fig.4. Debt/Disposable Income Ratio. Pg.8 Fig.5. April 2007 to April 2009. Pg.9 Read More