The Economics of the US House Price Bubble in the early 21st century


Term Paper, 2009
24 Pages, Grade: 1,7

Excerpt

Table of Contents

List of Abbreviations

List of Figures

List of Tables

1 Introduction

Problem Definition

Objectives

Methodology

2 The Advance of the Housing Bubble
2.1 The Asia Crisis 1997 - 1998
2.2 Fanny Mae and Freddie Mac

3 The Housing Bubble
3.1 Premises
3.1.1 The Role of the Fed and the Oversupply of Money
3.1.2 Lending Standards in the US
3.1.3 Prices of and Supply with new Houses over the last Decades
3.1.4 Securitization (ABS, MBS, CDO)
3.2 Housing Boom
3.2.1 Over financing
3.2.2 Consumption by Credit
3.2.3 Houses “Under Water”
3.3 The Final Crash

4 Conclusions

Bibliography

ITM Checklist

List of Abbreviations

illustration not visible in this excerpt

List of Figures

Figure 1: A credit boom gone bad?

Figure 2: US house price development

Figure 3: Collateralized Backed Obligations

Figure 4: Housing wealth and consumption growth

List of Tables

Table 1: Growth of GDP

1 Introduction

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.

Problem Definition

The housing bubble in the U.S and the following financial crisis had got their own reasons 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.

Objectives

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.

Methodology

The work on the assignment started with a mind map of questions like: who are participants 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.

2 The Advance of the Housing Bubble

The subprime crisis in the USA has its origins not only some years ago but can backtracked until the middle of the nineties of the 20th 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.

2.1 The Asia Crisis 1997 - 1998

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.

Table 1: Growth of GDP

illustration not visible in this excerpt

(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 sec- tor and therefore to less realistic ratings of the risks
3. Low interest rates in western countries and the need for good investment oppor- tunities

In the authors opinion the main relation to the US housing bubble is the run on good investment 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 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.

2.2 Fanny Mae and Freddie Mac

Private property is one of the main parts of the so called “American Dream”. In the 1990´s more than 60% of the Americans were able to live this dream and owned own property (Wagner 2009, p. 9). But the government wanted to increase this rate especially for middle and low income groups. In 1999, the two Government Sponsored Enterprises (GSE), Fannie Mae and Freddie Mac, came under pressure of the government to relax the lending standards for real estate mortgages to support especially the low income households, the so called subprime lenders (Holmes 1999). About the lending standards one can read more in the subchapter: Lending standards in the USA. The original task of the two mortgage banks was to develop private property. They worked both in the mortgage secondary market and collateralized mortgages. These mortgages were bundled to securities and sold to investors to get new capital for providing credits to low income households (Wagner 2009, p. 9). We will hear about that later in the subchapter securitization. But the lax lending standards have been already identified as risks in the late 90´s when the New York Times wrote that Fannie Mae took high risks which could run into trouble in the case of an economic downturn (Holmes 1999). And these lending standards led to unimaginable amounts of debts.

According to Business Wire, Fannie Mae Community Reinvestment Act (CRA1 ) loans reached $10 bn in 2001 and should be further raised to $20 bn for subprime debtors until 2010. The goal was to finance $500 bn of the CRA business in the whole USA (Business Wire 2001). Only some years later, between 2004 and 2006, the two banks “purchased $434 bn in securities backed by subprime loans” (Leonnig 2008). But already in 2003 the government wanted to install a new agency to supervise the two banks because they saw that the lending of money was out of control (Labaton 2003). In this year the two banks had together $1.3 trillion of outstanding debts and a growing portfolio. In 2004 the business of the two banks started to get criminal. According to Wagner an examination report stated that there were irregularities of around $10 bn between 1999 and 2004 (2009, p. 10). The report could proof that the CEO of Fannie Mae faked balance sheet because his bonus depended on the earnings of the bank.

So a lot of money has been pumped into the market without efficient control of strong authorities. In the authors opinion this development can be seen as one of the most important factors in the genesis of the housing bubble.

[...]


1 Community Reinvestment Act (CRA): established in 1977 to decrease discriminatory credit practices against low-income households (Bernanke 2007)

Excerpt out of 24 pages

Details

Title
The Economics of the US House Price Bubble in the early 21st century
College
University of Applied Sciences Berlin
Grade
1,7
Authors
Year
2009
Pages
24
Catalog Number
V197109
ISBN (eBook)
9783656231226
ISBN (Book)
9783656231684
File size
786 KB
Language
English
Notes
Tags
economics, house, price, bubble
Quote paper
Michael Kemmer (Author)Dirk Herfurth (Author), 2009, The Economics of the US House Price Bubble in the early 21st century, Munich, GRIN Verlag, https://www.grin.com/document/197109

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