Term Paper, 2009, 24 Pages
The Economics of the US House Price Bubble in the
early 21 st Century
Study Program Master of Business Administration (MBA)
1 st Academic Semester 2009
Berlin, July 03 rd 2009 Place, Date
ABS Asset Backed Security CDO Collateralized Debt Obligation CMO Collateralized Mortgage Obligation GDP Gross Domestic Product GSE Government Sponsored Enterprises MBS Mortgage Backed Security USA United States of America
Figure 1: A credit boom gone bad?.................................................................................... 7 Figure 2: US house price development ............................................................................. 9 Figure 3: Collateralized Backed Obligations.................................................................... 10 Figure 4: Housing wealth and consumption growth......................................................... 12
Table 1: Growth of GDP..................................................................................................... 3
The Economics of the US House Price Bubble in the early 21 st Century 1
Why do we have a financial crisis today? Apparently stable and profitable companies, banks and even markets begin to struggle. Where are the roots for this development? The financial crisis of today can be tracked back to the housing bubble and to the following housing crisis in the USA. But who where the participants and what were their actions? The following chapters try to give some explanations and reasons for this.
The housing bubble in the U.S and the following financial crisis had got their own rea- and drives. It is important to know these explanations and mechanisms to avoid such developments in the future. Managers and leaders should know, which reactions follow which actions.
The objective of this assignment is to explain the reasons for the U.S housing bubble and the mistakes made by the participants of this development.
The work on the assignment started with a mind map of questions like: who are partici- of the house bubble crisis, what are the connections between these participants, and what were their actions. All findings of this assignment are mainly Internet based and complemented by literature sources regarding topics like financial crisis, housing bubble, and subprime mortgage crisis. After providing a brief overview of the advance of the housing bubble, with a look to the Asia crisis, the premises of the housing bubble are explained. Following to that the housing boom is described in more detail. Afterwards, the focus will be changed to customer loyalty. Along with that the customer value and satisfaction is very important for a long term company-customer relationship. At the end of this assignment the conclusion sums up with the genesis of the housing bubble.
The Economics of the US House Price Bubble in the early 21 st Century 2
The subprime crisis in the USA has its origins not only some years ago but can back- until the middle of the nineties of the 20 th century (Dieter 2008, p. 2). In 1996, Alan Greenspan, the then chairman of the Federal Reserve Bank of the USA, was concerned about the development of the financial markets, but he did not anything about these concerns. Under his leadership several financial crisis have been countered by a laxly monetary politic of the Federal Reserve Bank (Dieter 2008, p.2). Beneath the War in the Gulf 1991 or the Mexico Crisis 1994 there was the Asia Crisis in 1997 and the Technology Bubble in 2001 which overlapped with the terror act of 9/11. In the next two subchapters the Asia Crisis as one crisis in advance of the housing bubble will be mentioned to illustrate the tide of events.
The Asia crisis was the most important event in the year 1997 and 1998. It makes sense to have a brief look at the progress and the causes of the Asia Crisis to understand if there were impacts at the USA and similarities to the housing bubble there. In the absence of much space in this work there can be only highlighted some major aspects of the Asia crisis. The affected states of the Asia Crisis had a relatively high average GDP between 1965 and 1995 as one can see in table 1. For this large growth rates one can find different explanations. On the one hand experts mention that the growth depended only on large investments in the region, on the other hand others say that the growth came from investments as well as from a growth of productivity (Dieter 1998, p. 6). These investments, which also led to current account deficits between -3% and -8% of the GDP in 1997, can be seen as one reason of the Asia crisis (Dieter 1998, p. 9). Private Banks and non-banks were engaged in Asia by providing short term credits which were very often used for real estate investments. This led to two premises which ended up in a crisis situation. The main problem was the double transformation. On the one hand credits were provided in foreign currencies, e.g. in US-$. On the other hand these short term credits were used for long term investments like real estates (Dieter 1998, p. 9). This leads in the end to a large foreign debt which was fragile against currency fluctuations.
The Economics of the US House Price Bubble in the early 21 st Century 3
Table 1: Growth of GDP
(Source: Dieter, 1998, p. 5)
Dieter mentions that especially the combination of deregulation of the financial sector and a booming domestic economy leads to a high explosive mixture because it is possible to get into debt in foreign countries (1998, p. 10). So internal measures against overheating become ineffective and lead to higher inflows of capital from foreign countries. The main problem of all these single events was that the creditor as well as the debtor trusted in the stability of the exchange rates of their currencies (Dieter 1998, p. 10). In the middle of 1997 the Thai Central Bank floated the exchange rate of the Thai Baht, what led to an exchange loss of 20% against the dollar. Other currencies also had big losses of value against the US-$. The example of the Indonesia Rupee, which was depreciated around 80% against the US-$ shows that the debtors had to pay back around four times more in their currency as before the depreciation. For the creditor this led to a lot of non payments because many companies became insolvent. The rating agencies made also their contributions to the crisis because they rated the Asian borrowers very good without having a look at the risks of currency fluctuations but reacted very fast on the first symptoms of the crisis (Dieter 1998, p. 13). Dieter concludes three main aspects which led to the Asia crisis (1998, p. 11):
1. The stability of the exchange rates over several years led to a deceiving security 2. The rapid growth in the Asian states led to a deficit of experts in the financial sector and therefore to less realistic ratings of the risks 3. Low interest rates in western countries and the need for good investment opportunities
In the authors opinion the main relation to the US housing bubble is the run on good in- opportunities because of a big surplus of money in the western countries. This led to excessive investments without analyzing the risks which was in this case the risk of changing exchange rates. To invest a lot of money it is necessary to provide this
The Economics of the US House Price Bubble in the early 21 st Century 4
money to the market. The next subchapter approaches this necessity and has a brief look at the role of Fannie Mae and Freddie Mac in the housing bubble.
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