During the boom period, mortgage underwriting standards dropped sharply. Automated Loan Approvals enabled borrowers to receive loans without having to submit any necessary documents. Nearly 40 percent of all subprime mortgage loans were originated from Automated Underwritings in Browning, Mortgage fraud by both borrowers and lenders persuaded massively before the crisis Cowen, Simkovic argues that the decline in mortgage lending practices was driven by a transfer from tightly controlled standards to widely used worse securitisation practices.
The role of Financial Institutions in the crisis Financial Institutions played a vital role in development of transmission mechanism through which international investments took place in the US Asset Backed Securities [ABS].
Financial innovations that were developed by financial institutions not only affected US but triggered recessions in number of global economies including European and Asian countries.
CDOs and MBSs which had prime and subprime mortgages in the pool lost its value after the underlying assets got bad due to dramatic decline in US house prices and foreclosure activities in Lander et al, ; Whalen, ; DiMaggio, Investment banks were serving corporate clients and commercial banks were serving private clients.
Commercial banks tried to get more customers by promising massive profit to lenders. However, based on optimistic expectations that the house prices tend to go up, commercial banks and lending institutions started to capitalise in the housing market by offering loose and affordable terms and conditions for mortgage loans such as low interest rate.
This scheme enabled too many customers to take mortgage loans and allowed the lending institutions to grasp massive number of customers in the housing market Aalbers, ; Gorton, The negative aspect of this scheme was the optimistic beliefs in house price appreciation. If prices get down, refinancing becomes difficult.
This is what happened at the beginning of the year So, investment banks come to play the role of serving the corporate clients. However, poor performance by investment banks and lending institutions can be considered as a major contributing factor to the SMC. Gorton argues that prime mortgages that had fixed rates were mixed with subprime mortgages for minimizing the overall risk of the MBSs. Senior RMBS bonds had AAA rating and the holders were paid first, however, it bore lower interest rate comparing to other bonds and its risk was predicated too low.
On the other hand; junior RMBS bonds had lower ratings and the holders were paid after the senior bondholders, while, a higher interest rate was set for junior bonds since its underlying assets were all risky. Senior RMBS bonds regardless of their AAA ratings had both prime and subprime mortgages in its underlying assets; therefore, they were almost risky like that of the other bonds which were rated lower.
MBSs are not the only products in mortgage securitization. The next one is CDOs. CDOs are issued as a special purpose vehicle [SPV] by special purpose entities and are backed not only by mortgages but variety of other products such as assets, bonds, and derivative instruments.
When the mortgage default rate increased, investors started to doubt about the CRAs performance, therefore, they have started to evaluate their activities. A CDS is a financial agreement wherein the seller insures the buyer against the risk of loan default. This financial swap agreement helps seller to receive fees on insuring the loan and enables the buyer to receive the face value of the loan in the event of default.
Most OTC derivative transactions such as CDS dealings were no longer regulated under the former restricted federal securities law. Instead, banks and other firms continued to deal in the market under a general and weak safety and soundness standards, this allowed careless regulation over CDS.
Later on it was considered as a contributing factor to the crisis. Stiglitz argues that the function of financial sector is to manage risk and allocate capital, the crisis happened as a result of misallocation of capital.
If they have invested money in right place then probably the US would have experienced a growth and stability in economy. Thus, we can conclude that the crisis was largely caused by the bad and poor behaviour of financial sector. All in all, financial institutions played the role of innovator as they have introduced risky mortgage products through which investors from around the globe started to invest in US housing markets.
In the section that follows, the reason for inappropriate behaviour of CRAs is discussed. CRAs went under inspection for having given inaccurate ratings to MBSs that had risky subprime mortgages in its underlying assets.
Partnoy believes that there were conflict of interest between CRAs and investment banks. As shown in figure 2.
This pressurized many firms and financial institutions to downgrade their value of MBSs and to borrow additional fund so as to maintain required level of equity ratios.
Investment banks were selling CDOs and RMBSs to wide range of investors including Hedge Funds and Pension Funds thus, the crisis not only caused people to loss their homes and jobs but also it caused many retired people to lose their savings for retirement.
Poor credit ratings and weak corporate performance by the CRAs exemplified failure of corporate governance in financial institutions that led to crisis. The following section discusses how the institutions failed to maintain good corporate governance. During the last two decades many firms in US failed to keep good corporate governance, thus, failure in corporate governance is not a new dilemma. The scandals of WorldCom and Enron in early s exemplified corporate governance failure in US firms.
Special Purpose Entities fueled the SMC by their risky and fraudulent activities such as taking the losses and liabilities off the balance sheet of firms and banks Solomon, ; Arbogast, ; Baker, Despite rating the securities, CRAs were also providing consultancy services to bond issuers. This created conflict of interest in between them. This speaks their faulty credit ratings and lack of corporate governance Calomiris and Mason, Between and ; top five investment banks in Figure 2.
Leverage ratio measures the level of debt to shareholders equity. This has activated the shadow banking system. Shadow banking system can be referred to situations when regulated institutions perform unregulated activities in stimulating credit creation across global financial markets.
Unregulated activities include credit default swaps dealings, unlisted derivative, and dealing with other unlisted instruments Reilly, However, loose government policy, lack of proper supervision on housing market, loose terms and conditions on loans, lack of appropriate guidance, rise in risky lending practices, weak securitization practices, inaccurate ratings, and lot many other unethical behaviours signified failure of corporate governance in financial institutions that have caused the crisis to happen.
Dropping the interest rate from 6. This caused the monthly mortgage payments to reset higher which then caused borrowers to go default Mastrobattista, ; Fed, The next chapter addresses the methods that are used to achieve the research objectives. Chapter 3: Research Methodology 3. In this dissertation, both qualitative and quantitative research methods are used to analyze data that are obtained from different secondary sources. Generally; there are two research approaches that are used to collect data and draw conclusion about a subject, namely: primary and secondary research methods.
Due to the wide extent of this research topic; it was required to incorporate data from so many existing sources, therefore, secondary research methods are used to complete this research paper.
The method is further detailed below. In this dissertation; discovering the causes of the mortgage mess, addressing relevant theories to the crisis, providing lessons and recommendations, and evaluating the role of different financial institutions who were involved in SMC required so many inputs from already established journals, articles, books and other secondary sources in order to best fit the literature review and conclusion part of this dissertation; therefore, a deductive approach of qualitative research method was used to meet these objectives.
While; to address major adverse consequences and effects of the crisis, several quantitative research methods such as regression analysis were used to answer those research questions and objectives.
UK has been selected as an exemplary economy that faced recession due primarily because of the SMC. Despite analyzing the impact of the SMC on US, conducting analysis on UK economy, on the other hand, helps to understand how far the crisis caused recession in those global economies. Section below addresses how the data has been gathered. Reliability and validity of information is very important to consider while collecting any data, therefore, the source should be carefully selected Dees, ; Saunders et al, Dochartaigh argues that online data is less reliable than published data, but, it can present reliable and valid statistical information if chosen carefully.
Nonetheless; due to the wide scale of this research paper, additional data was required that could not be retrieved from these government agencies. Therefore, other relevant and reliable sources were helpful in making this dissertation fruitful.
MSN money and Yahoo! Finance , for example, were helpful in retrieving financial information. Moreover; working papers, books, and journals are used to cover theoretical underpinnings of this research paper whilst web pages and articles are used to retrieve targeted and up to date information.
Since the SMC is not yet stopped; therefore, it was essential to obtain valid and up to date data. Deductive approach is a process of linking general theories with a specific topic of interest.
The theoretical underpinnings suggested that the crisis was systematic not subprime. Several graphical data are constructed by using Microsoft Excel. However; despite describing the impacts of the crisis in several graphical patterns, a regression analysis was also made to understand whether or not the US monetary policy caused recession in global countries, specifically in UK.
The section below describes the sample size and the pattern adopted to develop the regression models. Economic theory suggests that there is a time gap between the implementation of monetary policy and the response that we get back from the economic indicators.
In order to estimate the time length that takes for the US and UK economy to respond to the US monetary policy; two regression models have been developed through which we can find the reasons for the decline of UK GDP before the US economy. In the first model; the US GDP is the dependent variable and the federal interest rate is the explanatory variable. In both models; quarterly data for the period of Q1 to Q1 have been taken that constitute a sample of observations each. The results are presented later in chapter 4.
When the interest rates are decreased; businesses are encouraged to do more investments, individuals are motivated to spend a lot, and therefore, it leads to have an increase trend in GDP. In opposite case; when interest rates are increased, spending and investments go down which then leads to have decline trend in GDP of an economy.
Thus, there is a strong relationship between the GDP and interest rate of a country. Chapter 4: Findings and Analysis 4. Refinancing of loans was based on house price appreciation. When the house prices started to decline, as a result of several factors that has been discussed, subprime borrowers were no longer able to refinance their loans, thus, foreclosure activities began. The figure 4. As per figure 4. However; the index shows a fair growth of around 30 points during the period of January to January Nevertheless, an accelerated growth can be seen during the period of January to January where the point jumps from approximately to more than points.
The growth of this period is four times higher than the previous period of to Therefore, this accelerated growth had been signaling the property bubble and possibility was there that the crisis would have been controlled up to some extent if this enormous growth trend was observed carefully prior to the crisis. It is valid to argue that the losses would have been even higher if the real estate prices kept appreciating.
But housing bubble was possible to stop by controlling the factors that created the bubble. Figure 4. The theory of supply and demand suggests that fall in house prices can be explained by raise in supply of houses.
This is exactly what happened; the inventory of free and unsold US properties began to increase when the buyers left the market by the time the crisis happened. When the borrowers default rate increased in ; lot many homes went under foreclosure proceedings, thus, resulted to have more supply of houses. However; despite upward trend in housing prices, the supply of houses had also been increasing before the crisis.
As shown in figure 4. The supply of these additional 12 million houses along with the foreclosed properties increased the total supply of houses in US, therefore, today there are enough houses available in the housing market and the prices are unlikely to go up because of supply and demand factor.
However, it was the US monetary policy that has stimulated speculation in the mortgage market and motivated banks to lend loans to subprime borrowers. There are several ways through which US government controls supply of money in US such as; trading with treasuries and governments bonds, changing the reserve level on private banks, and changing the federal base rate for making desirable overnight loans the loans made in between the banks themselves.
The main focus in this section is on changes in federal interest rate. When the government increases the base rate on commercial banks; they in turn, also increases their rates on individual and corporate clients, thereafter, the rates on several things such as credit card, business loans, mortgage rates etc are increased.
Costly credit makes the households unable to pay out as much as they did in the past and causes less investment activities in the market.
While; on the contrary, cut in base rate encourages commercial banks to obtain more loans and lend money to so many individuals and businesses. This, as a result, promotes economic boom and increases commercial activities. The monetary policy of the government tries to spur business activities and increase employment during the time of economic slowdown and recession while; similarly, it tries to stabilize the economy in the times of economic boom by controlling the high inflation.
On the contrary; it can also destabilize the economy if its future consequences are not observed carefully. There is a time gap between brining changes in interest rate and the response that we get back from the economic indicators such as inflation rate, households spending, unemployment rate etc. Thus, it is valid to argue that changes in interest rate had an impact on SMC.
This created the opportunity for private banks to obtain cheap loans from the central bank and to enjoy receiving massive profit by lending more money to households and corporations.
As a result; the mortgage market attracted more customers and the housing prices went up and up gradually. By comparing figure 4. During the same period; as shown in figure 4. However, when the interest rate rose during to , the mortgage rates also increased substantially.
Therefore, it can be argued that the US monetary policy influenced changes in the housing market. An assumption could be made that the Fed lowered down its base rate in order to increase business activities and provide job opportunities to people. During to ; when the federal base rate was set low, the unemployment rate stopped increasing since several investment activities toke place and businesses started to hire more people.
Hence, the US labor market progressively improved until because of the US monetary policy. Nevertheless; during to , as presented in figure 4.
As a result, the unemployment rate jumped higher once again. Why the Fed did that? A fair answer can be suggested that the US government tried to save US dollar from depreciation in its value and to take control of inflation growth.
By looking carefully at figure 4. If the interest rate was not raised in ; the crisis would have happened with a deferment and delay, the housing market would have received more clients, the institutional investors would have traded even more MBSs and CDOs, thus, the rise in interest rate during helped to reduce the potential worse consequences of the crisis, though the consequences are still worse but delays might have caused even more cost than the current.
Therefore, an assumption can be made that rise in interest rate by the Fed was to take care of the massive losses beyond the current one.
The effect of the crisis on unemployment rate of both US and UK is further detailed in section that follows but prior to that, another factor that should be looked at is the stock market crash. In early ; dotcom firms were failed to provide justification for their overvalued share prices, therefore their collapses caused crash of NASDAQ stock market and the event was referred as a dotcom bubble that had negative affect over the US economy.
It was the first market that offered online trading in USA. It was the big fall ever in its history. Several measures were taken by the US government to recover its economy after the stock market crash. Adding on; in order to generate income, people are investing in shares of different firms; thus, a share can be referred as a wealth of a person.
Less consumptions cause decline in GDP of an economy and this is how the dotcom bubble caused economic slowdown in US by early The mistake of the Federal Reserve that caused the housing bubble lies in lowering down the interest rate too low during to UK, for example, has experienced enormous side effects of the crisis for three main grounds.
First of all; due to active international trade between US and UK, the affect of the crisis was transmitted. Second; the UK investors and lending institutions, Northern Rock for example, actively played its role in US mortgage market. When the crisis broke out in , all those institutions suffered losses.
Lastly, since the banking systems are connected globally, they are trading in between themselves to maintain required level of liquidity and to help each other. When the financial system in US was crashed by the SMC; the banks turn into insolvency and were incapable to help each other both at international and national level. As a result, the liquidity crisis spread out all over the world and affected so many countries.
The following sections highlight the impacts of the crisis on several economic indicators. A collective index of both UK and US is illustrated in figure 4. When the banking sector faced liquidity problem starting in due to the SMC, individuals and firms found it hard to obtain loans since the banks were reluctant to provide them. Therefore, the unemployment rate in both US and UK substantially increased thereafter. Thus, it can be argued that decline in consumption, production, and other sector of the economy was due to the unavailability of credits.
Consequently; when business activities slowed down, the demand for more labors decreased. The unemployment index of both US and UK shows upward trends after the crisis.
Any collapse of the U. Hedge funds and banks created mortgage-backed securities. The insurance companies covered them with credit default swaps. Demand for mortgages led to an asset bubble in housing. When the Federal Reserve raised the federal funds rate, it sent adjustable mortgage interest rates skyrocketing.
Hedge funds are always under tremendous pressure to outperform the market. We use cookies for a number of reasons, such as keeping FT Sites reliable and secure, personalising content and ads, providing social media features and to analyse how our Sites are used. File Name: us subprime crisis creator. By using our site, you agree to our collection of information through the use of cookies. To learn more, view our Privacy Policy.
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Maria Muntahin. A short summary of this paper. Introduction The subprime mortgage crisis caused the U. When the subprime crisis unfolded, it first affected the real estate market and then the economy overall. To understand what subprime mortgage crisis is first we have to know what subprime mortgage or subprime lending is.
Subprime lending is when a commercial bank lends money to people who have low credit rating or cannot require the credit requirements. As they cannot provide insurance for themselves to deserve the loan, they are required to pay higher interest rates for their borrowed fund.
Subprime mortgage is similar to subprime lending in which low credit rated borrowers can borrow money at a high mortgage rate against collateral which might be a property they want to buy with the borrowed fund. Proponents of subprime lending maintain that the practice extends credit to people who would otherwise not have access to the credit market.
When the price of real estate started to fall, the subprime lenders started to default their mortgage payment. As a result, the mortgage originators foreclosed the mortgages and owned the collaterals. Now as the price of the assets is much lower than the mortgage value, when they tried to sell those in the market, they incurred a pretty big loss.
In brief, this was the subprime mortgage crisis which occurred in the United States during Phases in the Crisis The whole crisis was not built in a day.
It all started years ago before the crisis unfolded. There were three distinct phases in formation and outcomes of this crisis. The phases are 1. Effect on Financial Market. Response from Federal Reserve and the Government. That highlights the identification problem in looking at bubbles. As Ben Bernanke put it, while the price of an asset is observable, the corresponding fundamentals such as the expected return from the asset are not.
That house prices have boomed relative to rents is clear from chart 2 and the take-off since is self-evident. But unless inflation is allowed to get out of control, there will be a limit on rental increases. The boom in house prices was driven by historically low interest rates and a lack of perceived returns on stock markets following the bust of the stock market boom in Following the share slump, changing perceptions of relative returns on assets caused investors to switch holdings of assets in favor of housing.
As investors switched preferences from stocks to property, rising prices of houses generated expectations of further rises in property values, fuelling additional speculative demands. Initially, the inventory of unsold homes rises before price pressure is felt. Even so, there can be large effects. In one study on bubbles bursting the IMF found that housing price busts were less frequent than stock market busts but they lasted twice as long and were associated with output losses that were twice as large.
The IMF found that on average, the output level three years after a house price bust was 8 per cent below the level based on average growth rates before the bust. What has pundits worried is the sharp 12 per cent drop in US sales of existing homes over a year ago while sales of new homes is down 17 per cent.
There are plenty of unreliable stories of US house prices 20 per cent below asking prices a year ago but nationally the market only seems slightly down. Across the United States, the National Association of Realtors reports the median price of existing homes to be 1. More price pressure could be expected, however, since the inventory of existing homes available for sale is 7. The shadow in the housing markets is also reflected in the Housing Market Index collected and published by the National Association of Home Builders.
Their index has declined to its lowest level since Consistent with this decline in the index, dwelling investment in the United States is also off 15 per cent as shown on the chart. Reasons behind the Housing Bubble The US housing bubble was potentially caused by regional government restriction of land supply, federal laws that increased the demand for homes, and foreign cash inflows.
The regions affected were properties in the metropolitan areas of the east and west coast. This raised demand and gathered momentum after Reagan left office when the White House pressured HUD housing and urban development , the Attorney General, The Federal Reserve and all institutions with regulatory authority over banks to pressure them to make loans to low income Afro- Americans using racial statistics. Fannie Mae and Freddie Mac were pressured to lower their down payment requirement as well.
In Congress passed the American Dream Down Payment Act which subsidized the down payments of low income home buyers. The Federal Reserve began raising the rates in By the rates were 5. The foreclosures followed increasing supply dropping housing prices further.
Obsession for Home Ownership Americans' love of their homes is widely known and acknowledged; however, many believe that enthusiasm for home ownership was high even by American standards, calling the real estate market "frothy", "speculative madness", and a "mania". As interest rates—and mortgage payments—have started to climb, many of these new owners are having difficulty making ends meet Those borrowers are much worse off than before they bought.
The overall U. Bush's campaign slogan "the ownership society" indicates the strong preference and societal influence of Americans to own the homes they live in, as opposed to renting. Suspicious Activity Reports pertaining to Mortgage fraud increased by 1, percent between and Belief that housing is a good investment Among Americans, home ownership is widely accepted as preferable to renting in many cases, especially when the ownership term is expected to be at least five years.
This is partly due to the fact that the fraction of a fixed-rate mortgage used to pay down the principal builds equity for the homeowner over time, while the interest portion of the loan payments qualifies for a tax break, whereas, except for the personal tax deduction often available to renters but not to homeowners, money spent on rent does neither.
However, when considered as an investment, that is, an asset that is expected to grow in value over time. However, as opposed to the utility of shelter that home ownership provides, housing is not a risk-free investment. The popular notion that, unlike stocks, homes do not fall in value is believed to have contributed to the mania for purchasing homes.
Stock prices are reported in real time, which means investors witness the volatility. However, homes are usually valued yearly or less often, thereby smoothing out perceptions of volatility. However, housing prices can move both up and down in local markets, as evidenced by the relatively recent price history in locations such as New York, Los Angeles, Boston, Japan, Vancouver, Seoul, Sydney, and Hong Kong; large trends of up and down price fluctuations can be seen in many U. The investment motive for purchasing homes should not be conflated with the necessity of shelter that housing provides; an economic comparison of the relative costs of owning versus renting the equivalent utility of shelter can be made separately.
Instead of a supply vs. When it comes to crashing economies and creating bubbles, no-one does it better than the federal reserve. When a countries entire banking system is run by privately-owned foreign interests, market booms and busts were inevitable.
The ironic truth is that former Fed chief Alan Greenspan actually encouraged use of sub- prime loans. With these advances in technology, lenders have taken advantage of credit scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. Where once more marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately.
These improvements have led to rapid growth in subprime mortgage lending. Fostering constructive innovation that is both responsive to market demand and beneficial to consumers. Potential home owners and fence sitting home buyers were manipulated by an industry tactic known as Fear of Being "priced-out" of the housing market forever. Quotes like "home prices never fall" and "real estate only goes up" were common sales tactics with realtors and home sellers everywhere.
Renters were ridiculed as being naive and "missing the boat" on real estate blogs and in conversations about housing "owning vs. Millions of people across the nation were led to believe that if they didn't purchase a home immediately then they would be priced out of the housing market forever.
However, past performance is never a guarantee of future performance in any market, especially a bubble market. Many exotic mortgage products were used to help potential home-buyers "qualify" for the loan. No-document loans, known in the industry as "liar-loans", were everywhere from big banks to small-town mortgage companies who didn't bother requiring a home buyer to actually have income to cover the mortgage payments.
Down payments were no longer required in many cases. They anticipated Ever-rising home values would outweigh possible bad-loans and prevent even the jobless from missing payments. Homes became ATM machines for families to cash-out equity for home improvements, automobiles, vacations, furniture and more. Needless to say the mortgage companies and loan officers loved their hefty, although temporary profits. Media Propaganda: It is no secret that real estate is big business. And big business means big profits for the advertising agencies.
The media was a major contributor in pumping-up the housing bubble. The real estate industry became a leading source of revenue for many newspapers, magazines, billboards, radio stations and more.
Articles were printed that promoted the buying of homes and making renters feel like they were fools for not buying a home.
Money and finance magazines printed articles about the masses getting rich on real estate. Newspapers would print articles that had real estate agents saying that home prices are rising rapidly in because "everyone wants to live here" or because the local economy was great. Real estate advertising everywhere was heavily involved and profited heavily by the mega housing bubble that was sweeping across the nation.
Mortgage and Appraisal Fraud: Rising home prices were enticing to crooks too. Dozens of cases a month of mortgage fraud and appraisal fraud became common in counties across the US.
Appraisers were pressured by lending institutions to inflate appraisal prices so the loan could close. Mortgage companies became telemarketing monsters who would call homeowners over-and-over again until the papers were signed, sometimes without disclosing the terms of the loan or plain-out giving false information to the customer and many times forging documents to alter signatures, income, or other data to get the loan closed.
This caused a surge in fraudulent mortgage applications, false appraisals, and planting straw-buyers to purchase over-valued homes. Realtors on Commission: Real estate agents across the nation, and especially in hot markets, began to see ever increasing profits due to earning higher commissions on the sales of bubble priced houses. A higher home price equals higher commissions for the Realtor selling the property. During the real estate "boom-years", it wasn't uncommon for real estate agents in hot markets like Florida, California, Arizona, and other areas to make hundreds of thousand dollars a year for selling bubble priced houses homeowners.
Simply put, if you're paid on commission, a higher selling price and therefore a housing market bubble is a welcome event.
Instead of negotiating a better deal and lower sales price for the buyer, realtors were not on the side of the buyers because it was not in the their best interest to have a lower selling price on a home because a lower price meant less commission for them.
Home buyers were encouraged to bid and bid higher as homes received sometimes multiple offers, thus raising the price even higher, all to the selling realtors delight. Foreclosures Double Edged Sword: Foreclosures hurt the housing market in multiple ways. Banks are not in the property management business and will sell an empty home at fire-sale prices to avoid upkeep and maintenance.
While there are many factors that influenced the housing bubble, fundamentally a bubble is built one transaction at a time. Risky lending decisions were made by institutions and risky borrowing decisions were made by both individuals and institutions.
These bonds represent the first mortgage-backed securities MBS. These loans are referred to as "qualifying" or "prime" when they meet the GSE underwriting standards. The GSEs have missions that included helping provide housing to lower-income Americans by purchasing mortgages from originating firm. A small percentage of these loans were non-prime. A variety of politicians supported this mission both formally and informally.
Investors demanded MBS, as they were considered safe investments that paid a higher rate of return than treasury bills during the boom period, when defaults were minimal. Credit risk insurance was available through credit default swaps CDS. Both MBS and CDS are relatively opaque investments and once the bubble burst, their valuation became difficult to determine.
Credit rating agencies are paid by those whose instruments they are rating. Non- banks did not have the same leverage restrictions as commercial banks. These included adjustable-rate mortgages and interest-only payment terms.
Many homeowners were encouraged to purchase high-risk mortgages due to the belief that increasing home values would enable them to pay for the property. This is reinforced widely in the culture, through television and movies. America is a consumption-oriented culture, with a negative savings rate. During the housing boom, many made significant profits through speculation or heard stories of massive home appreciation. The housing bubble developed for over a decade, with housing prices peaking in June-July With such an upward trend, housing seemed a safe investment, particularly after the dot-com bust.
Bubbles are primarily social phenomena; until we understand and address the psychology that fuels them, they're going to keep forming. This further drove demand.
However, at some point, demand decreased a shift to the left in the demand curve , or stagnated at the same time supply increased, resulting in a sharp drop in prices - and the bubble bursts. The Forces that Cause the Bubble to Burst The housing bubble bursts when excessive risk-taking becomes relentless throughout the housing system. This happens while the supply of housing is still increasing.
In other words, demand decreases while supply increases, resulting in a fall in prices. This pervasiveness of risk throughout the system is triggered by losses suffered by homeowners, mortgage lenders, mortgage investors and property investors.
When rapid price appreciation stagnates, those who count on it to afford their homes long term might lose their homes, bringing more supply to the market. The bottom line is that when losses mount, credit standards are tightened, easy mortgage borrowing is no longer available, demand decreases, supply increases, speculators leave the market and prices fall.
There are several reasons which aided the housing bubble burst in USA. The reasons are as follows: Excess Housing inventory: One of the main reasons behind the housing bubble burst in USA was Excess housing inventory. There are already a large number of house inventory available in the USA market comparing to the buyers of the houses. As the supply of the housing inventory was larger than the demand of the house so gradually the price of the house is going down.
At the same time, there were approximately 8 million homes in the shadow inventory available in the USA. The shadow inventory included all loans 90 days or more behind on their payments, most loans that are days behind, and properties that are already foreclosure. The investment banks estimated that at the rate of current home sales, it would take 47 months for USA to clear the "shadow inventory" of houses. Of course when these homes end up on the market, they inflate an already large supply of homes on the market which can drive down home prices further.
According to the very basic economic principle, lower prices should lead to more homes being purchased. In case of USA, in this time this principle did not hold for long. There were some reasons behind this problem. So they are not that much interested to buy new homes. In the year three million home are going into foreclosure.
At the same time, excess housing inventory is expected to continue to rise in Analysts are predicting an additional 3. The federal home loan modification program is a part of the economic stimulus program which seems to have had little effect on the rate of foreclosing. There are also some several reasons behind this situation.
The reasons behind the continuing rise in foreclosures included excessive numbers of adjustable rate mortgages that would reset at rates that were unaffordable to many.
Housing price decline: The housing price of USA is substantially decreasing through a long period of time. There are many reasons which are responsible for this situation. Prices are still dangerously high compared to incomes and rents. At the same time according to the Landlords a safe price is a maximum of 15 times the house's annual rent.
Another reason for declining the price of the house is as it was still much cheaper to rent than to own the same size and quality house, in the same school district.
In this situation, renters win and the same time the owners lose. So buying a house is still a very bad deal in the richer neighborhoods, but it does make sense to buy in some relatively poor neighborhoods where prices have already fallen into line with salaries and rents.
The thick red line represents nominal house prices. The thick blue line represents real house prices. The chart shows that the real prices of houses are always lower than the nominal price of the hoses. At the same time the real prices of the houses are increasing and the prices are not fluctuating over times. There was Sharpe increase in the real house price during the year but the real price started to decrease just after the increase.
In case of nominal price, it was always much higher than the real price as the inflation is much higher. The nominal prices were not increasing over time but the prices were used to fluctuate very frequently.
Again there was a Sharpe increase in the real price in just like the nominal price. Reasons behind the housing price decline: The housing price in USA decreases substantially through a long period of time for various reasons.
The reasons are as follows: 1. The ratio of House Prices to Income has also increased significantly from the long term average. This means they are more vulnerable to any changes in the housing market.
Over the long run, home prices and rents should increase at roughly the same rate. But in this case there is a sharp increase in the housing price during the year and then after that the price started to decrease. But the house rent was increasing at a constant rate. Aggressive sale of Sub Prime Mortgages Usually when house prices rise, demands for houses becomes moderate.
In case of case of the US housing market, mortgage lenders were desperate to maintain sales.
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