Real Estate Meltdown
Real estate meltdown, otherwise referred to as the ‘housing bubble’ refers to a period where housing prices decline across the United States further leading to the financial crisis of 2007-2008. These lead to fears that the country was headed back to a depression similar to the Great Depression of 1945. There has been a lot of explanations as to what lead to the housing meltdown, but the real question is, could it be possible that the crisis could have been avoided? My aim purpose in this paper is to bring into discussion why the disaster should have been averted and if we are at risk of facing it again.
To arrive at my goals, first, we would have to look at what were the causes of the housing meltdown in the period 2006- 2008. With the crush of the housing market, economist and financial pundits came up with many explanations as to what lead to the bubble some of which the extent of their impact yet to be determined. It is therefore important to realize that a single factor did not cause the decline in the housing market but a number of them together.
Decline In Mortgage Interest Rates
In economics, we learn that when the rate of savings is low, interests tend to go high. However, that was not the case during the housing bubble. Mortgage rates were little despite saving rates being low mainly because of saving getting into the US economy from outside countries like China and Japan. According to Bernanke (2009), the net savings from outside the country increased from an estimate of 1.5% of GDP IN 1995 to 6% as of 2006.
With the aim of making better returns from investment at lower risk, investors moved from US government securities to mortgage-backed securities that Freddie Mac and Fannie Mae issued. They receive sponsorship from the government, and investors expected that in case of unforeseen circumstances the government would bail the two out. Hence they were low risk.
In addition to a real estate meltdown, mortgage-backed securities received better ratings issued by one of the best rating agencies like Standard & Poor. With the housing prices rising, low mortgage interest rates had a hand in the housing bubble by enabling more house buyers to afford to pay their monthly dues. According to Robert Schultz, increase in the speculation house prices is what made the prices to go up steadily. Speculators did purchase housing at a lower cost to sell when prices go up. With regards to the 2001 period of recession, the Federal government lowered interest rates to keep the economy going. Hence the second cause of housing meltdown.
Reduction In Short-Term Rates of Interest
From 2002 to 2004 the government lowered interest rates with the aim of making a recovery from the earlier recession of 2001. It affected the housing bubble because with the constant rise in the housing prices while household income is remaining steady, homeowners were not able to afford a payment of their mortgage loans at current rates and therefore resorted to adjustable mortgage rates which were preferable at the moment. However, when the rates began to rise, this proved to be unmanageable for homeowners.
The other way was because of leveraging, that is where loans borrowers used their borrowed money to invest. It, therefore, encouraged mortgage lending and thus increasing house prices. When the housing bubble hit, the high level of leverage that was present in the economy worsened the decline in the cost of housing.
Lack Of Strict Rules on Issuing of Mortgage Loans
During the period after the recession, the government of President Bill Clinton did not impose strict rules to financial institutions on the issuance of mortgage loans with the aim of increasing the number of homeownerships. With a reduction in the mortgage fees increased competition among mortgage loan issuing firms and therefore they had to relax their standards to obtain their market share. By the fact that there were securities issued on mortgage loans prompted this.
An increase in subprime mortgages which refers to mortgages issued to persons that were likely to default demonstrates this. Although these kinds of mortgages charged higher rates due to the risk, the all practice was not worth it.
The fact that everyone believed that prices of housing would go up did contribute to the bubble. According to Robert Shiller (2005) in his book ‘irrational exuberance’ which refers to high levels of speculative fever had indeed added to the housing bubble. From house buyers, mortgage lenders, rating agencies to even the government, none of them ever imagined that the prices of housing would ever go down.
Why The Housing Bubble Could Have Been Avoided – Real Estate Meltdown
From my analysis on the factors that lead to the housing, all the above factors did contribute to the bubble, but the main factor being the pointless speculation that the housing prices would continue going being on the rise and there was no reason to suggest otherwise. That is why, according to Robert Shiller (2005) irrational exuberance in any price bubble is difficult to notice, very hard to prevent and neither is it of value to avoid.
However, this could have been avoided if only the players who took part in the excessive speculation of prices of housing could have thought otherwise. The belief by credit rating agencies and foreign investors that prices of house in the US would go up was the primary factor that encouraged mortgage interest rates to remain so low. This notion also leads to a rise in the level of leverage experienced in the economy. The reason being low-interest rates encouraged borrowing for investment on housing with prospects of making good returns upon prices increasing.
I also think that the government regulatory agency should have regulated the constant rise in prices of housing. It could have lowered the speculation and hence chances of leverages being experienced in the economy being minimal. A control of Investment banks and mortgage issuing agencies was necessary. There is supposed to be a set of rules to be followed. Without rules there are chances of thing running out of control.
I also believe that then the government did not receive a better monetary policy to adopt. With the constant rise in prices of housing, it was not in the best interest of the federal government to lower bank rates to increase the number of house owners. The pricing of housing is similar to any other item, the law of supply and demand applies.
The Possibility of Another Bubble Leading to Real Estate Meltdown
There has been a lot of speculation in the media that we are about to experience another housing bubble just a decade after the last occurrence that leads to a financial crisis in the economy. Currently, the average cost of purchasing a house is quite high compared to ordinary income. It is one of the aspects that we need to watch out. Mortgage lenders on the other side are much strict, and real estate investors have hard time to make sells with housing staying as long as three months without being sold. There is a belief that prices of housing are going to return to normalcy the moment investors having high desires of making good returns leave the market. It is only a speculation, but with the current state of house prices I cannot rule out the possibility of another bubble.
Real estate is indeed a venture that is quite rewarding, but this may change as we have seen from our discussion on the events of house prices bubbles. However, I believe that prevention was needed long before it occurred by required government policies through regulating the prices of housing. Indeed it is necessary not to leave any stone un-turned since we cannot rule out the chances of another bubble. We can learn from its experience and be ready to prevent its re-occurrence.
Holt, Jeff. A summary of the primary causes of the housing bubble and the resulting credit crisis: A non-technical paper. The Journal of Business Inquiry 8.1 (2009): 120-129.
Schwartz, Herman M. Subprime nation: American power, global capital, and the housing bubble. Cornell University Press, 2009.
CQ Press Research, ‘Mortgage Crisis and Real Estate Meltdown ’ (Nov 2007); 926-927
Gramlich, Edward M., and Robert D. Reischauer, Subprime Mortgages: America’s Latest Boom and Bust, Urban In-stitute Press, 2007.
Cheng, I. A., Sahil Raina, and Wei Xiong. “Wall Street and the Housing Bubble: Bad Incentives, Bad Models, or Bad Luck?” University of Michigan mimeo, April (2012).
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