The Bursting of the Housing Bubble
The bursting of the housing bubble took the US economy completely off guard. The term "housing bubble" is commonly used to identify the start of the housing crisis in 2008. The term "housing bubble" refers to a period in the real estate industry when the housing market expanded enormously and property values climbed above average. The housing crisis was driven by a number of factors that all worked together, and different economists have different opinions about what caused the mortgage debacle. According to one scenario, the value quality of subprime loans gradually declined in the six years preceding the crisis. The government weakened the mortgage underwriting standards which consequently increased speculation, which brought fast rise in mortgage defaults when the prices of homes stopped appreciating (Zandi). There are many more theories. However, there is no simple explanation of the housing bubble, and so this paper will look at some leading causes of the housing crisis and the effects of the crisis on the economy.
The Role of Low Mortgage Interest Rates
Most economists are in consensus that the most apparent cause of the housing bubble was the low mortgage interest rates. Though the U.S. savings rate was flat during the housing bubble, an inflow of saving entering the U.S. market from nations such as China and Japan kept mortgage interest taxes low. Investors from the mentioned countries pursued investments providing comparatively low risk and favorable returns (Holt).. Mortgage interest rates in the U.S. increased to18 percent in the year 1982, as the Federal Reserve drove interest rates upward in a fruitful attempt to crush inflation. Mortgage interest rates mostly fell over the subsequent two decades, with the rate on a 30-year fixed mortgage falling below six percent later in 2002 (Sowell). Countries like Japan, China, and United Kingdom high savings rates and investors from such countries sought low-risk returns especially in the government securities sector, but later the investors shifted mortgage securities. Furthermore, with Wall Street firms providing good reviews for the mortgage securities, the investors grew bolder by vigorously investing in the housing market (Holt). Eventually, the low mortgage interest rates fueled the growth the housing bubble by keeping monthly loan payments cheap for many buyers even as housing prices rose.
The Impact of Low Short-term Rates
Secondly, the low short-term rates contributed to the housing crisis. For about two years from 2002, the Federal Reserve lowered the federal fund's rate down to historically low levels in a bid to strengthen the recovery from the recession of 2001 (Holt). The federal government lowered the interest rates from 6.5 percent to 1 percent by the year 2003. However, inflation remained stagnant. The low short-term interest rates stimulated the application of adjustable rate mortgages (ARMs). As housing costs rose faster than household incomes, many potential buyers couldn't afford house payments under fixed-rate mortgages. However, ARMs could provide the customer with a lower monthly fee initially since short-term interest rates were lesser than long-term interest tolls. As the housing economy appreciated, mortgage creditors became more creative with ARMs. The economy developed optional ARM, where the borrower could choose to make regular payments of both principal and interest hence decreasing the balance outstanding on loan each month. The debtor could also decide to make payments of interest only (thus not altering the balance remaining on loan monthly), or could even choose to make payments of only a percentage of the interest due. ARMs made monthly mortgage payments affordable temporarily for many buyers and therefore led to rising of home prices (Krugman). When the mortgage interest rates adjusted upwards, the higher mortgage payments proved impossible to manage for most home buyers.
The Role of Irrational Exuberance
Thirdly, irrational exuberance played a pivotal role in the housing bubble. According to (Shiller), irrational exuberance is "a heightened state of speculative fervor." The participants involved in the housing bubble included the government controllers, foreign investors, mortgage creditors, investment bankers, insurance companies, credit rating agencies, and home buyers acted on the assumption that home prices would continue to increase. Since home prices had not dropped since the Great Depression, many people anticipated that they would not fall. Government regulators felt it not necessary to regulate the appreciating home prices. Mortgage lenders made increasing numbers of subprime mortgages. Investment bankers went on to issue exceedingly leveraged mortgage-backed securities (Krugman). Credit rating agencies continued to give highest ratings to securities supported by subprime and adjustable-rate mortgages. Foreign investors continued to inject billions of dollars into highly rated mortgage-backed securities. Insurance companies continued to sell credit default swaps (an insurance contract) to investors in mortgage-financed securities since the companies would face little liability on the contracts. Home buyers continued to buy homes even though the monthly payments would eventually prove hard to manage. All the mentioned participant's actions would have been fruitful had the housing prices continued to rise.
The Impact of Relaxed Mortgage Standards
Finally, relaxed standards of the mortgage significantly contributed to the housing crisis. Several factors resulted in the relaxed mortgage standards (Zandi). The factors included the new policies created to foster an increase in homeownership rates among lower-income households, increased competition in the mortgage credit market, the increasing inspection of home mortgage debt, and the irrational exuberance that prevailed. The government created new policies that encouraged or even forced the banks to relax mortgage lending rules through the Community Reinvestment Act for low-income homeowners. (Zandi)The internet increased competition for mortgage investments. The internet provided a broader platform for favorable creditors and eventually mortgage fees and further decreased the lending standards. The irrational exuberance caused a further relaxation of mortgage lending standards as the market continued to overheat. Lenders didn't bother to investigate long-term worthiness of the debtors and banks bought more mortgages to sell more. The increase in subprime mortgages (mortgages given to people considered to be a poor credit risk) further relaxed lending standards.
The Impact on the Economy
The housing crisis had a far much terrible effect on the economy. The aftermath of the bubble saw the unemployment rate rise to over 10 percent. During the crisis, there was a large number of foreclosures of many financial firms, a record of over 3 million foreclosures. Homeowners incurred hefty losses and so did much business where thousands of companies lost up to 30 percent of the firm's market values. To crown it all, the U.S market, in general, experienced the worst depression since the Great Depression (Krugman).
Conclusion
In conclusion, irrational exuberance is blamed by many as the main contributor to the other mentioned three causes of the housing crisis. The three reasons as discussed were low mortgage interest rates, relaxed mortgage lending standards, and low short-term rates. The adverse effects of the housing crisis are the high rate of unemployment, millions of foreclosures, losses incurred by homeowners and financial firms and, finally, the general depression of the U.S economy.
Works cited
Holt, Jeff. "A Summary of the Primary Causes of the Housing Bubble." The Journal of Business Inquiry (2009): 120-129.
Krugman, P. The return of Depression Economics and the Crisis of 2008. New York: W. W. Norton & Company., 2009.
Shiller, R. J. Defination of Irrational Exuberance. 2005. 1 December 2017 .
Sowell, T. The Housing Boom and Bust. New York: Basic Books, 20009.
Zandi, M. Financial Shock: A 360° Look at the Subprime Mortgagea Implosion, and How to Avoid the Next. Upper Saddle River, New Jersey: Pearson Education., 2009.
