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A review of the US housing market crash of 2007-2008 & forecasts for the future Essay

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Paper type: Review

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The severe decline in the state of world economy in the last two years is a culmination of several factors. But the bursting of the housing bubble in the United States alongside a precarious credit crunch situation have played major roles in precipitating the latest episode of economic recession in many countries. While the advanced nations in North America and Western Europe have borne the brunt of the recession, lesser developed economies and several emerging markets are simultaneously experiencing a slowdown in economic activity. Financial analysts and political commentators point out that the unregulated financial markets of Western democracies make such crises inevitable. The proponents of free market capitalism, on the other hand, do not concede this point. This essay will foray into the conditions that led to the present crisis in the housing market and try to assess the merits of remedial policy measures in this regard. The evaluation of the stimulus and bailout packages is followed by an inquiry into policy directions for the coming years. It will also place the prospects of the housing market in the broader context of revival of the economy both in the United States and abroad.

The Federal Reserve, which has the power to decide the course of the economy, has been criticized for its lack of foresight. Although the actions of the Federal Reserve in the initial years of the Bush Administration are to be credited for the housing boom, exercising fiscal prudence could have mitigated the present crisis. According to John Gnuschke,

“Daily evidence of the continuing erosion of the housing market, the associated disruption of financial and credit markets, and the spill-over impacts to other segments of the real estate industry are taking their toll on the broader economy. While the real estate industry continues to be a major component of the economy, the dramatic and overly-aggressive increases in interest rates promoted by the Federal Reserve Bank (between 2001 and 2007) have caused a major disruption in national and international markets”. (Gnuschke, 2007, p.4)

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Another reason for the decline of the housing market is the unmitigated expanse of mortgage lending across income groups. In spite of being warned by the former chief of Federal Reserve, Alan Greenspan, the financiers continued to ignore unpleasant realities. The transition of Chairmanship from Alan Greenspan to Ben Bernanke has so far not brought a change in the policy direction. When the markets are booming and there is plenty of credit available due to reduced interest rates, it is tempting to ignore warning of impending doom. This is precisely what precipitated the collapse of the housing market in particular and the economy in general. For example, lenders such as HSBC, who own the American company Household International, thought of mortgage lending as a lucrative opportunity to make profits. Such willing lenders catered to low-income individuals, who were keen to take advantage of the apparent rise in house values. At the same time, new financial market instruments such as ‘sub-prime mortgages’ were introduced. In other words, “the mortgage debts, offering better-than-usual returns (because of the low quality of the borrowers) would be packaged up into neat parcels–known technically as “collateralized mortgage/loan obligations”–and parked with banks and investment funds around the world” (Alex Brummer, 2007, p.17). It is easy for unsuspecting low income investors to succumb to the lure of these complex derivative products. But in reality, their real value is significantly lower than what is quoted in the financial markets, the latter being the result of speculation.

But the high risk contained in these sub-prime mortgages was not nominal but very real. This precarious balance was sustainable only as long as the housing prices remain affordable and interest rates remained low. And it did not take long for Greenspan’s fears to turn to reality.

“No sooner had Greenspan spoken than the housing bubble burst. Prices across the United States plunged. House builders were left with unsold stocks and the sub-prime mortgage lenders found not only that they had lent funds to people who had no realistic prospect of paying back, but the securities against which they had lent were worthless. HSBC alone lost [pounds sterling] 5bn.” (Brummer, 2007, p.17)

Financial experts also failed to take into account the likelihood of inflation. This misplaced optimism was to prove a disaster. For example, the belief that inflation is a thing of the past encouraged financial institutions to borrow money long-term at very low interest rates. But when energy prices remained high for a protracted period and demand for commodities from emerging economies increased substantially, it made borrowing money close to impossible. In this scenario, the bond markets started to reverse direction, and longer-term borrowing turned more expensive once again. The financial institutions that had borrowed cheaply did not expect the sudden rise in the cost of transactions. But, most of these financial institutions, including such names as Goldman Sachs, Bear, Stearns & Co., Barclays Capital, etc manage to evade negative consequences, as they had “repackaged debts of all kinds, including sub-prime mortgages, into derivative products known collectively as asset-backed securities” and passed it on to market participants. Speculative rallies further inflated the price of these securities (Roubini, 2008, p.45).

The prices of these securities spiraled upwards, seemingly without an upper limit. Their complexity had made price rationalization an impossible task. Sooner rather than later, the speculation inflated bubble collapsed and has led to the severest economic crisis in over seventy years. While the epicenter of the crisis is in the United States, its repercussions have reached all corners of the world, including such emerging economies as China and India. As Alex Brummer explains, this phenomenon could not sustain forever:

“Such vehicles–Goldman Sachs’s Global Alpha fund, for instance, and several operated by Bear Stearns–were able to extract the maximum value from securities by borrowing against them and selling them on. Fabulous returns were made using sophisticated computer models. But as the sub-prime mortgage situation became worse and such lenders as the giant Californian company New Century Financial collapsed into bankruptcy, it dawned on nervous investors that the emperor had no clothes.” (Brummer, 2007, p.17)

The prevailing financial crisis can also be seen from an historical perspective. For example, many of the events and conditions that led to the present decline of the economy were similar to those leading up to the Great Depression of the 1930s. Then as is now, deregulation is seen as the chief culprit. Especially, during the tenure of the Bush Administration, the financial economy had repeated many of the same mistakes incurred during the 1920s. These excesses include stretching of borrowing limits to underwrite numerous speculative bets with money derived from the vulnerable middle class. Some of these financial mechanisms were poorly regulated, making the eventual economic crash inevitable. But, it would be simplistic to point fingers at the Bush Administration alone. The seeds for the disaster were sown further back in American political history. For example, in the last three decades, the Presidents of both parties, with the support of the Congress repealed important protective mechanisms from the original New Deal legislation. As a result, instances of exorbitant profits for business corporations have risen while real productive growth has been replaced by complex financial products such as derivatives. This, as a whole had made American economy vulnerable to recession (Roubini, 2008, p.46). Alongside derivatives, overpriced equities, inflated real estate prices and other complex financial instruments have played a role in creating the economic bubble. The bubble is further inflated by speculative borrowing, which feeds on itself, as it did during the Great Depression. This is so because an inflated asset is suitable collateral for further borrowing. To state that deregulation played a role in creating the bubble would be an understatement. In fact, the deregulated business and financial environment inevitably leads to periodic recessions. For example, in the years leading up to the current crisis, “the ratio of stock prices to corporate earnings is not quite as high as it was in 1929 or 2000, but it is still very high by historic standards” (Kuttner, 2007, p.20). As the author further explains,

“For decades, real-estate prices have appreciated faster than incomes. This could not go on forever, because a house is worth only what some buyer can afford to pay for it. Lately, housing prices got an extra nudge from artificially cheap mortgages extended to people who didn’t really qualify for credit. Mortgage companies could make these sketchy loans because some other speculator was willing to take the loans off their books, and because they expected housing prices to keep rising, adding a cushion of equity. Thanks to deregulation, the entire game operated largely beyond the purview of bank examiners.” (Kuttner, 2007, p.21)

When initial signs of an economic recession were visible in the horizon, the policy makers did not act expeditiously. Toward the end of Bush Administration’s tenure, there were ominous signs of an impending recession, but the actions taken since then are not substantial enough. For example, in his final State of the Union speech, President Bush mentioned about the need for an economic stimulus package. There were talks of a $150 billion bailout package that would include tax rebates and other incentives to encourage consumer spending and investment in the near future. Moreover, under the proposed plan, taxpayers would get rebate checks, which would put disposable money directly in the hands of consumers – an idea that got bipartisan political support. Yet, in spite of encouragement in the House of Representatives, the plan does not measure up when seen in the backdrop of the severity of the economic crisis. For instance, the unemployment rate has reached its highest level in last sixty years. Added to that is the dismal state of the manufacturing industry. The consolidation of the European Union and its common currency Euro is posing a serious threat to the strength of American dollar. Considering all these factors, the measures taken so far prove inadequate. The plan is also ridden with technical flaws. As William Hoar points out, “With both major parties offering spurious solutions for the economy, the bipartisan fix is bound to be even worse for the nation in the long run than a partisan one. The shot in the arm that the politicians are pushing is a shot of more debt–involving the spending or rebating of money that the government does not have. All that this remedy will boost is the budget deficit.” (Hoar, 2008, p. 42)

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