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Business Economics. Housing Crisis

Introduction

In the United States, two problems are seen as the root of the housing crisis that people are experiencing today. These problems are: foreclosure of homes and the falling values of houses. Furthermore, today a lot of people are now pointing their finger at the housing crisis in the United States as the cause of the global economic turmoil.

Families in the United States of America are currently having difficult times in trying to settle their mortgage payments. At the same time, as the value of real estate properties keeps on declining, the real estate owners are actually incurring losses from their homes instead of gaining value from appreciation of those properties. The economy of the United State has been greatly affected by this slowdown in the housing industry. Many are bothered that the United States will go into recession. Recession in one of the worlds’ biggest economy means a bad thing for the rest of the worlds’ investment and lending structure. (ForeclosureDeals Corporation, May 2008).

The crisis revealed the enveloping flaws in the regulations in the financial industry and the financial system around the globe. The effect of which is a huge fall in the capital of a large number of banks and enterprises that are sponsored by the United States government, which in turn, made credit grants around the world tighter.

Reasons for the Problems Encountered in the US and Global Housing Market

There are various and complex causes for the housing market problem in the United States and the world. The problems can be traced to many factors that envelop both the credit and housing markets.

A lot of mortgages in the United States that were issued in the latter years of the 20th century were subprime. Subprime mortgages are mortgages with a very minimal or no down payment made. These are granted to households with relatively low incomes and assets as well as with dark credit histories. As the prices of houses in the United States started to decline in 2006-2007, the delinquencies in mortgages became higher than expected, thus the securities that are supported by subprime mortgages that are held mostly by financial firms suffered a steep decline in value.

These factors materialized as time passed by. These causes that analysts points out as the possible root of the housing market problem involves that lack of ability of homeowners in keeping up with the payment of their mortgage dues. The poor judgment of borrowers and lenders also contributed to the problem. The speculation and excess building on the boom period are also factors to consider. Mortgage products that are risky and the high level of personal and corporate debt also contributed to the crisis. The concealment of the risks involved in the financial products during mortgage default is also blames as a reason of the housing market problem. The monetary policies and regulations by the government are also seen as causes for the problem. Furthermore, the moral hazard can not be ignored as the cause of this problem. (Brown, 2008)

The start of the crisis is often blamed to the unaffordable interest-rate resets. It is said that many of the subprime borrowers that defaulted managed very well in their mortgage payments on pre-reset dates. Before the crisis, interest rates are low and there are huge amount of inflows from foreign funds that made credit conditions easy. As a result, more people had the ability to obtain housing loans in the pre-crisis years. In fact, the home ownership rate in the United States increased from 64% in 1994 (compared to 1980 figures) to a very surprising 69.2% in 2004 (US Census Bureau, 2007). A major part in the rise of home ownership in the United States and in the general increase in housing demand can be attributed to subprime lending. Because of the increasing value of property, many are encouraged to buy houses in anticipation of appreciation of the property value by applying for adjustable-rate mortgages. This increased the demand for houses. As a result, much more capital is invested in the housing market, although claims are in the form of debt or mortgages. The building boom created excess unsold homes. The adjustable-rate mortgages will charge the borrower an interest rate lower than the market interest rate for some definite grace period and increases for the rest of the mortgage’s term. The defaults on fixed-rate loans are less sensitive to declining housing prices compared to the defaults on subprime adjustable-rate mortgages (Foote, et al., 2008).

Many borrowers were unable to pay the higher payments thus they chose to refinance their mortgages. Consequently, refinancing became tougher when prices of houses started to decline in a lot of parts of the United States. Borrowers defaulted as a result of the inability to settle the monthly payments. As house prices continue to decline, most homeowners have negative equity in their houses, meaning, the amount of mortgage is greater than the value of the property.

With regard to the falling house values, in the mid 2007, house prices have decreased by 15%. The decline in the value of property is due to several factors. One of these factors is the shortage of mortgages that are available because of the credit crunch. Another factor is the poor affordability ratio of prices of houses to income. The lack of trust to the housing market also contributed to the falling of house prices. Of course, nobody will buy a house during times of falling property values. The feared recession and the increasing unemployment also stop people from buying houses (Pettinger, 2008).

As borrowers, defaulted, the bank foreclosed the properties. This unexpected increase in foreclosure rates further increased the number of houses available in the market thus further amplifying the decline in house prices. Because banks and other financial firms have equities backed with mortgages, their value also declined. House prices are expected to decline until the excess inventory of houses are sold and returned to their normal level.

Speculative buyers are also contributors to the housing market problem. Buyers who are anticipating that property values will continue to rise during the building boom bought more properties even though not intended for residential purposes but as investment property. Homes are not really treated as investment properties traditionally, but the housing boom altered this behavior. More housing units were purchased for investment purposes. In fact a total of 40% of the housing units purchased during 2005 and 2006 were not really intended for primary residences but for investment purposes. In 2006, the speculative buyers started to leave the market, thus made investment sales of housing units fall very fast. As the buyers leave, they left a housing market with a lot of excess inventory of housing unit which contributed to the decline of housing prices (Uchitelle, 2008).

Also contributed to the housing market problem was the granting of loans to higher-risk borrowers which includes illegal immigrants. These subprime mortgages totaled to $35 billion in 1994 up to $600 billion in 2006 (Demyanyk, et al, 2008). Borrowers are given different financial products. One of which was the adjustable-rate mortgage. This offers the borrower a “teaser rate” of below 4% which doubles after some time. After the interest rate increased, the borrowers were unable to pay the monthly payments. Another payment scheme is the so called “payment option” loan which grants the borrower the choice to pay any variable amount, but if there are any unpaid interest, it will be included in the principal. This made payment even more difficult. Underwriting practices of mortgages are also blamed for the problem. This includes the automated loan approvals which do not involve a thorough review of the credit history of the borrower. In 2007, it is reported that 40% of the subprime loans were approved from automated underwriting (Browning, 2007).

Securitization is also blamed as the cause of the housing market problem. Securitization is a form of structure finance which entails the pooling of financial assets most especially for those that do not have an available secondary market, like mortgages, student loans, and credit card receivables. The assets that have been pooled will serve as collateral for the new financial assets that the entities like GSEs and investment banks, will issue. This shifts the risk of borrowers default from the lender to the investor of security. As a result, lenders’ credit standards can be downgraded because after all, they will not be the one who will carry the risk of borrower’s default (Lewis, 2007). Because of the relaxation of the credit standards, more subprime borrowers were able to obtain the loans. As the borrowers defaulted the owner of the claims on the mortgage, who are the investors which includes financial firms around the globe, suffered the losses upon borrower’s default.

Credit rating agencies are questioned for giving MBSs and CDOs backed with subprime mortgage loans with high-quality ratings. It is believed that the high ratings are just appropriate because of the risk reducing practices involved. Surprisingly, some people associated with the process of rating the subprime-related securities are aware that the process of rating the said securities are defective. These are evidenced by electronic mails exchange between rating agency employees. Due to the high rating that the securities supported by subprime mortgages, investors are lured to buy those securities. A lot of investors treated the securitized products, most of which backed with subprime mortgages, as equal to better quality securities. This problem was amplified by the SEC’s elimination of the regulatory barriers and the lessening of required disclosures. It is perceived that there are conflict of interest that exists between the investment banks and some firms that arrange and sell the structured securities to the investing public. On the 11th of June, 2008, the SEC gave proposal on how to alleviate this alleged conflict of interests. As a result, between the third quarters of 2007 and second quarter of 2008, the rating agencies downgraded the rating given to $1.9 trillion worth of mortgage backed securities (Hunt, 2008). In effect, in order to sell more securities, financial institutions must lower the price of their share. Thus, the lowering of credit rating triggered the decline of the stock prices for a lot of financial firms.

Government policies and lack thereof contributed a lot to the crisis. It is perceived that the present American regulatory framework is already out-of-date. Former United States president George W. Bush said that the financial regulatory structure of the country must be updated after the crisis is put to an end. Furthermore, the self-regulation of investment banks also played a role in the crisis. The federal government supported on the mortgage industry in order to achieve the goal of increase in the home ownership ratio. This led to the lowering of lending standards. In order to finance the housing boom, the GSE purchased mortgage backed securities. Fannie Mae and Freddie Mac were mandated by the government to make buying homes more affordable for the people, especially for those who have an income below the median in their respective area. The Department of Housing and Urban Development (HUD) set the target for Fannie and Freddie. The HUD wanted Fannie and Freddie to purchase mortgage-backed securities, and out of those securities, 52% should have been issued to low income households. From 2002 to 2006, the collective purchases of Fannie Mae and Freddie Mac increased from $172 billion to more than $500 billion per year. Furthermore, because of these buying activities, plus the high yields that these securities generate, many were enticed to purchase mortgage-backed securities. U.S. Congressman Ron Paul predicted that poor credit tolerance and high leveraging by the GSE would result in bailout. He introduced a house bill in order too eliminate these policies but it was rejected.

The central banks are institutions that administer monetary policies and target the inflation rate. They possess authority on commercial banks and other financial institutions. Central banks generally do corrective actions rather than preventive ones. Once an economic bubble burst, they react in order to lessen the economic damage. The reason for this is that it is difficult to identify an economic bubble and the appropriate monetary policy in order to control it. A moral hazard existed when the Federal Reserve Bank of New York rescued the long-term capital management in 1998. Big financial institutions feel that the Federal Reserve will rescue them when their risky loans get out of control. The house prices rose during the pre-crisis times because of the actions taken by the Federal Reserve to mitigate the dot-com bubble. The Federal Reserve lowered interest rates. They believe that the lowering of interest rate is safe because the inflation rate was low. In fact, the rate of inflation was misleading because it is lower than the true inflation rate. The excessive lowering of interest rates led to the housing bubble.

Credit defaults swaps are contracts of insurance between financial institutions which is used to protect debtholders from the risk of default. As the probability of default related to mortgages increased, and the net worth of banks and financial institutions decreased, the insurers need to pay their counterparties. This generated uncertainty on the part of the investors on which who should be obligated to pay to cover the defaults on the mortgage.

Impacts of the Housing Market Problems on Global Business Activity

The impact of the housing problems escalated in 2006. It affected not only the housing industry but also other industries within and without the United States.

Financial firms all over the globe that has holding of subprime related securities written down their value by US$501 billion as of August 2008. Defaults in mortgages and provisions for defaults in the future led profits to decrease from $35.2 billion in the last quarter of 2006 to $646 billion in the last quarter of 2007. The problem started to affect the banking and finance sector in February 2007 when one of the worlds’ largest bank, HSBC, written down a $10.5 billion worth of subprime-related holdings. The rest of 2007 became gloomy because at least 100 other mortgage companies either suspended operations or shut down or sold. Top executives of financial institutions resigned one after another. As the crisis became worse, a lot more financial institutions sought for merger partners or merged with other companies.

The Dow Jones Industrial Average registered a record high of closing above 14,000 on July 19, 2007. Dramatically, the Dow declined below 13,000 on August 15, 2007. The Standard and Poor 500 crossed out negative territories in that year. The same scenario was witnessed in every market around the globe. Brazil and Korea were the worst affected countries. Up to 2008, huge drops on every trading day appeared to be common. Mortgage creditors and home constructors suffered the most losses. Other industries were also affected very hard by the losses. Surprisingly, the metal and mining industry, with a very vague association with mortgages and lending, were one of the worst-hit industries. Stock indices globally went into a downward trend for long period of time starting from the first panic in July 2007.

A major sell out of securities was witnessed during the panic in the financial markets. Investors pull out their trillions of dollars of investment on equities and mortgage bonds into some other like food and raw materials. Speculation triggered the world food price crisis and the dramatic increases in the price of oil. Beginning in the mid of 2008 the major stock indices of the United States (Dow Jones, NASDAQ, S&P 500) all showed sharpest drops since the terrorist attacks in 2001. Another major event that time was the declaration of bankruptcy by the Lehman Brothers investment bank.

Lehman Brothers is one of the investment banks that issued large amount of debts in order to invest the proceeds for mortgage-backed securities. Once the prices of the securities began to drop because of the decline in the prices of houses and mortgage defaults became more frequent, investment banks such as Lehman Brothers suffered huge losses. In addition, two other investment banks, Merrill Lynch and Bank of America, share the same sentiments with Lehman Brothers. In order to stay capitalized, they entered into a forced merger amounting to $50 billion.

To sum it all up, the Dow Jones declined 504 points or 4.4% and the S&P 500 plunged 59 points or 4.7%. European and Asian markets showed the same very sharp drops. Despite the passage of the bailout legislation, the Dow Jones index plunged even further. The market in 2008 experienced the worst trading weeks in the Stock Market since the terrorist attacks in September 2001.

The housing problems affected a large number of people and industries around the globe. The decrease in house prices diminished wealth of households and the collateral for loans on home equity which resulted to a downward pressure on household consumption. Arson and other crimes related to houses increased. Large number of people lost their jobs in the financial sector, with figures reaching over 65,400 jobs in the USA on September 2008. Tenants of houses being rented were evicted from their homes because the property of the landlord became subject to foreclosures. Tightening of credit was also experienced. This resulted to a significant drop in the sales of automotive vehicles. It was observed between October 2007 and 2008 that General Motors sales dropped by 15.6%, Ford sales plunged by 33.8% and Toyota sales were down by 32.3%. Just recently, automotive companies expressed their worries that they will declare bankruptcy in the near future. It is expected that 20% of car dealers will close in the end of 2008.

The US and global housing problem which is caused by a multitude of factors that accumulated over time is now causing havoc not only in the United States economy but also in all parts of the world. The crisis is a collaborative effort of different flaws of the US regulatory policies and other inherent market behaviors. Expectations on how long this crisis will last differ. Only one thing is sure, not unless the causes of these problems were addressed, similar situations will be experienced in the coming future.

Bibliography

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