The Financial Crisis and the Housing Bubble

Introduction

Considered as one of the greatest financial crises of all time, the 2008 global recession has rarely been understood by most individuals. Eight years on and there a lot of misinformation on the main causes of the financial quagmire, with most people and misinformed shallow economic analysts still has the belief that the financial market deregulation and Wall Street greed were some of the root causes. It is important to understand that the housing bubble and the complexity that surrounded the securitization of the housing finances were also a factor. The problem started in the mid-2007 when the seemingly housing bubble boom turned into probably one of the greatest financial crisis since the 1930 Great Recession. This paper takes a look at the 2008 financial crisis and the role that the housing bubble played. The paper explores the causes for the growth of the housing bubble boom and looks at the circumstances which permitted the housing boom to explode into the recession and cause an impact on the financial sector of the United States and probably the whole world.

 

The Financial Crisis

The 2008 global financial crisis can be associated with various factors mostly related to financial policy regulations, rates as well as financial imbalances which were being experienced globally (Friedman). But the financial quagmire could have been easily prevented considering there were signs which showed a possible financial crash as well as important lessons from the previous crises. There were a lot of misconceptions during the pre-financial crisis with most economic analysts believing that there was nothing to worry about probably because a financial recession had not been preceded a house bubble growth.

But there were notable similarities and lessons from previous financial crises such as an increase in the prices of houses and equity in financial markets which led to a surge in the deficit in the current account and debt. It is also worth noting that there was a lot of financial exposure of investors as a result of the security of mortgages and loans. This led to a lot of instability in the financial markets which led to the aversion of risks by investors. The main cause of the financial crisis can be attributed to the housing boom that was taking place in the early 21st century with a lot of exuberance galvanizing the bubble creating a financial environment that led to the crisis. There was the existence of cowboy financing which fed the housing growth allowing it to grow to levels that would have been prevented in a financial system that is regulated.

The Housing Bubble

The growth of the housing bubble was complementary to the stock bubble that took place at the end of the 20th century (Macdonald). The growth was as a result of an increased expenditure by people who had amassed wealth from the stock market. Due to an increased amassing of wealth, there was an increased consumption by the end of the century and a reduced savings rate with the disposable income falling to 2 percent from 5 percent which was recorded at the mid-90s.The increase in wealth from the stock market led to a boom in consumption especially regarding houses with bigger homes being bought. This led to an increase in demand in the housing sector which caused the bubble due to the fixed supply of the houses at that specific time. With an increase in demand and a fixed supply, an unprecedented increase in price took place and the increase became incorporated into expectations. This was because the homebuyers felt there would be a continued increase in price in the homes and therefore led to more home buying. This led to the expectations to be self-fulfilling.

At the same time, the rise in inflation led to the increase in the price of houses which had remained unchanged for the last decade. In 2002, the price of houses had increased by almost 30 percent due to inflation (Shiller). With a history of stability in the home prices, it could have been noted that the prices of houses was speculative and not market fundamentals. The speculative house bubble could have further been evidenced by the rise in the rents by close to 10% in real terms. In the case of market, fundamentals increasing the prices of houses, the increase in rents and house prices would have been comparable and complementary, but the increase in rent was lower than that of house prices.

As a result of the increase in the prices of houses and rents, there was a great impact on the supply side. To meet the increase in the demand for the homes, there was an unprecedented increase in the housing starts between the mid-90s and the late 90s. By the early 21st century the number of house starts had increased by almost 25% which was above the average (Shiller). The increase in the construction of houses became too much that led to an over-supply leading to increased vacant homes to near 10 percent by 2002 as compared to 7% which was recorded in the mid-90s.

A comparison of the housing bubble in the United States and Japan clearly showed that there was a looming financial crisis in the United States. If the housing bubble had been similar to that in Japan, then the stock and housing bubble would have collapsed simultaneously in the early 2000s. But on the contrary, the fall of the stock bubble in the US is what led to the birth of the housing boom as the finances were being transferred from the stock market to the housing sector. The housing sector was seen as a much safer option for investment as compared to the volatile stock market.

Furthermore, a slight recession felt in 2001 had an effect on the economy with a decrease in employment until 2003. With a weak and slow recovery in the economy the Federal Reserve Board reduced the rates of interest which cut the rates of the federal funds to almost 1 percent. As a result of the reduction of federal interest rates, the mortgage rates followed suit falling to a 50 year low of 5.25% for 30-year fixed rate mortgages. The housing market further exploded with the suggestion by the Federal Reserve Board advising home buyers to use rate mortgages which were adjustable rather than the fixed rate mortgages. The low rates of interest led to an increase in the prices of houses with an additional 31% being recorded in the last quarter of 2002 and the last quarter of 2006. This was an annual increase of 7.5%. The increase in prices led to more house building and starts with a peak of over 2 million houses being recorded in 2005 which was a 50 percent increase in the early 90s (Shiller). With an increase in the house prices, there was a decrease in disposable income and savings but increased spending. The rates of savings decreased to 1 percent by 2007.

The increase in the building and construction led to an over-supply leading to unsustainable prices. This led to more people owning homes with record vacancies being recorded in the rentals than owned homes. By the last quarter of 2006, the rate of vacancy of owned homes was above 50% with the prices peaking in the next year and subsequently beginning to fall. The fall of the house prices further went through the year 2007 and 2008. With the subsequent decrease in the prices of the homes, most of the owners faced foreclosure. The foreclosure was either voluntary or to an extent involuntary. There were instances when home owners felt than the value of the home was much less than they expected and would rather not pay the mortgage.

The foreclosure of homes subsequently led to an increased supply of houses in the market. By the start of 2008, the foreclosures accounted for almost 60 percent of the homes in that quarter. There were regions where the number of home foreclosures was more than the number of homes which were sold which further led to reduced prices and increased supply. The same phenomenon happened to the demand side of the equation with lenders tightening their standards as a result of the increase in default rates in 2007 and requiring strong securities for the loans (Shiller). This was not the case in the run-up to the housing boom where the banks were relaxed and never cared too much about the security of loans. The regulation and tightening of lending g standards became more severe to the extent that most potential homeowners could not get loans to buy homes. Most banks in the market stipulated up to 25% of the total cost as down payment. The standards led to the exclusion of most home buyers and even existing homeowners because the increase in the prices of the homes had led interfered with much of their equity.

At the start of 2008, the prices of most homes had fallen by almost 17 percent with homes in prime regions such as the coast had decreased by almost 20 percent. To make matter worse, the rate at which the price of the homes was decreasing was faster than anticipated with an annual rate of 30%. It was predicted that the prices of houses would fall by 30 percent of their prices at 2007 by the end of 2008. The calculation gave an average of $100,000 lost per month for every home owner which translates to close to $7 trillion dollars in the housing sector. This was approximately half of the GDP which led to a huge financial strain on the economy.

The Financial Meltdown and Housing Crisis

The housing bubble became evident after the increase and fall of house prices in the mid-2000s. The volatility of the housing market led to an increase in the rates at which borrowers defaulted specifically in the overrated housing markets. Most of the defaulting were registered in the subprime market since they were the most vulnerable. The home owners in the subprime market had no any retirement accounts or any family members who could help or guarantee the mortgage payments in case they defaulted. Therefore with the lack of equity to serve as security for their homes, the homeowners in the subprime market became easy defaulters.

Most of the defaults on home loans began in 2007 and were mostly used for refinancing homes and not purchasing of mortgages. The mortgages were marketed to homeowners who had low or moderate income so as to give them extra finances to meet the bills for making better homes (Wiethuechter 80-95). As a result of these mortgages and the volatility of the market most of the families who had taken unsecured loans suffered from foreclosures or repossession of their homes. With a sharp increase in defaults of rates in the market, there was a reduced valuation of the mortgage-backed securities and the derivatives which were part of the securities. Most of these instruments and derivatives were exposed to huge risks posed by the subprime markets which led to several squeezes of credit which had an impact on the financial markets at the start of 2007 (Wiethuechter 80-95). The investors had no confidence in the securities that was offered regarding assets as they could not gauge the extent of the debt that they were exposed to.

There were also serious effects of the financial meltdown in the housing sector. With most of the homes of the homes foreclosed due to the biting economy, an increased supply of houses were placed up for sale with most of the lenders panicking and having the urgency to sell the foreclosed homes (Wiethuechter). The foreclosed homes were many to the extent that the number of foreclosures exceeded even the number of houses sold between 2007 and 2008. With an increased supply of homes, the demand decreased with the strain that was being felt on the finances and the economy. The lenders also realized that there were no regulations and set standards for giving loans and mortgages and with the falling prices they started to demand huge down payments with strict income and asset documentation. The number of people who became eligible for a loan reduced amicably as they did not meet the necessary requirements.

With reduced demand and increased supply, the prices of homes began to decrease rapidly. The prices of houses fell by an annual rate of 20 percent at the start of 2008 with a huge percentage decrease in markets such as Los Angeles and Las Vegas. The stabilization of the prices of the homes was very unlikely even though there were hopes that the decline would stop by the end of 2008. The housing bubble finally came to an end but led to a huge financial instability and turbulence (Tomohara and Sherlock). The banks had already undergone huge loses of defaulted loans with a total loss of close to $1 trillion. There were extra write-downs which further hit the market causing the bank to undergo insolvency and posting financial strain on the mortgage lenders such as Fannie Mae and Freddie Mac. The recession was further deepened by the weak market of houses as well as the exposure of the financial markets.

Even though the financial crisis was solved by the start of 2009, there was a further decrease and instability in the housing market. Close to 3 million homes was foreclosed in 2009, and the rate of unemployment rose abnormally past 10 percent (Tomohara and Sherlock). But it became quite evident that the crash of the housing market created one of the worst financial quagmires in the history of the U.S. By the last quarter of 2009, the financial recession had been amended and the U.S registered an increase in the growth of the GDP with earning in the corporate sector being at an optimum level. The unemployment rate had been stabilized, but the prices of houses had not stabilized as there was still a surplus and people were recovering from the financial shock of the recession.

With the housing boom being a prime cause of the global financial crisis, there were serious impacts for the government and the individuals especially with an increasing unemployment rate as well as biting economic times. The impact of the crisis was to different degrees in various countries with some being affected more than others dependent on the status of their economies at the start of the recession. But it is without a doubt that the financial crisis could have been prevented if there were stringent measures and regulations to control the financial market which was monopolized by the lenders (Shiller). At the same time, there could have been mechanism instituted to control the global financial imbalances.

Conclusion

The financial crisis of 2008 was caused by many factors but largely as a result of the emergence of the sub-prime housing market. The market emerged as a result of increased incentives by lenders and people harboring goals of owning homes. This led to an increase in the borrowing business by the banks and lenders who mainly targeted potential home buyers. With an increased lending trade, the standards and requirements for lending decreased and ‘non-prime’ loans emerged as a result. Unsecured loans became rampant to the extent that close to 50 percent of the loans that were either for sub-prime or for home equity.

The growth of the housing sector before the financial recession is what created a situation with poor standards of lending where any individual could apply for an adjustable rate mortgage. Here were very enticing conditions for the loan that included very low down payment with low-interest rates. But the housing boom was further fueled by more speculations. In conclusion, it is without a doubt that the housing bubble which was caused by the fall of the stock market was one of the prime causes of the financial recession of 2008. Other factors could also be poor regulation of the financial systems as well as global imbalances of the various strong economies.

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Jul 3, 2020 in Marketing Essay Samples