Housing Bubble and Financial Crisis. The Historical Link!

The USA experienced the worst financial crisis and recession between the year 2008 and 2009. This had been preceded by the housing bubble that was experienced between the mid 90’s and 2005. The increase in demand for housing resulted in an inflation fueled ride in price of housing and a resultant oversupply of housing units that were un affordable to the masses. This saw the government put pressure on mortgage lenders to provide affordable housing, a move that saw monetary policies being distorted and the credit sector being unregulated

This Essay elaborates the conditions which led to the bubble, discussed how unusual monetary policies, unwise regulations and misguides federal policies allowed the bubble to grow to risky levels and eventual result that placed unprecedented strain on the country’s financial system. It lastly outlines key principles that can be applied to revive the financial system.

In the mid 90’s the stock markets experienced a bubble. There was increased spending based on the wealth accumulated from stocks. This increase in consumption saw a drop in savings rate from close to 5% in the middle of the decade to slightly above 2% by 2000. (Dean.B.2008).

Consumers spent their stock wealth in purchasing better houses for status and as investment. The immediate result of this was an increase in demand for housing. In the short run however, supply for housing is relatively fixed, which resulted in an increase in prices.

As the demand went up, prices continued to rise creating a predictive environment in the housing industry. With the predictions came expectations which were fulfilled when buyers willingly paid more get housing. There was a bit of panic buying embedded with consumerism with led to a continued rise in pricing.

By 2002, there was an increase in investment in real estate which was result of the predicted continued increase in prices. The housing market saw an increase in supply of over 25% and this was the start of the housing bubble. A report by (Shiller. R. 2006) shows that houses prices had risen by almost 30% by 2002 whereas they had remained fairy unchanged in almost 100 years preceding 1995 as seen in the chart below.

By 2002, there was an increase in investment in real estate which was result of the predicted continued increase in prices. The housing market saw an increase in supply of over 25% and this was the start of the housing bubble

Fig. 1: Shiller R’s plot of U.S. home prices, population, building costs, and bond yields.

The chat shows that the inflation influenced home prices in the US increased at a fairly constant rate from 1890 to around 1940 where a sharp increase was experienced.

The same cannot however be compared to the increase experienced between the mid 90’s and 2005 when the prices hit a record high.

In 2001 after the recession, the federal government under the Department of Housing and Urban Development advocated for expansion of mortgages to unqualified borrowers with an aim to offer affordable housing. This form of non-traditional mortgages would see a borrower being qualified for a loan by wavering either one or two of the C’s: collateral, credit score and capacity. Down payment standards for mortgages were lowered by the Feral Housing Administration to below 10%. A move that saw many previously incapable borrowers access mortgage loans.

The government fueled these risky loans through its supported mortgage lenders Fannie Mae and Freddie Mac through the treasury using the cheap money policy of the federal reserve. After the 2001 recession, the Federal funds rate was slashed from 6.25% to 1.75%, and further to 1% in 2000. (Dean. B. 2008).

The two government supported mortgage lenders experienced massive expansion through this credit funded scheme. They grew to own or guarantee almost half of the $12 trillion mortgage market (Roberts. R. 2008).

In the years prior to 1996, the Housing and Urban Development required that Fannie and Freddie have 12% loan classified as “special loans which were allocated to borrowers whose income was less than 60% of the localities’ median income. That number had however been increasing with it going up to by 8% in 2000 and a subsequent 2% in 2005. (Lawrence H.W. (2008). These increases were as a result of funding loans worth billions of dollars most of which were under the non-traditional mortgage type, The borrowers were given adjustable interest rate and regularly prequalified. In this plan of mortgage, borrowers pain less than 10% down payment.

The result of the above plan was a need by Fannie and Freddie to borrow money in wholesale from the public and investors willingly put in monies because they trusted that the government would pay back. But the eventual outcome was a supply that out did the demand and the government failed to assure investors of market stabilization measures.

In the long term, what was intended to be remedy to the housing short supply ended up being a crisis in the financial sector. The way forward is to identify the policies that led to this failures and distortions in the housing market and undo them. The agencies of this change who implemented the failing policies also need to be dismantled as it was in their jurisdiction to assess ad predict the long term effect of such effect and offer precautionary measure. Alternatively guidance by policies that promote sustainable development should be the main focus.

References

Dean B. (2008). The Housing Bubble and the Financial Crisis; real-world economics review, issue no. 46, 20 May 2008, pp. 73-81. Retrieved from

Dean. B. (2002). The Run Up in the House Prices. Is t Real Or Is It Anther Bubble? Washington DC. Centre for Economic Research.

Shiller. R. (2006). Irrational Exuberance (3rd edition), Princeton. NJ. Princeton University Press.

Roberts. R. (2008). How Government Stoked the Mania. Wall Street Journal. October 3, 2008.

Lawrence H.W. (2008). “How Did We Get into This Financial Mess?” Cato Institute Briefing Paper no. 110, November 18, 2008.

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