The time when the bubble burst

In my previous post I talked about financial crisis, their causes and consequences. Now, I will try to analyze why did the Subprime Crisis or the Housing Bubble Crisis took place.

Observers and analysts have attributed the reasons for the 2001–2006 housing bubble and its 2007–10 collapse in the United States to the following:

  • Home buyers
  • Wall Street
  • Mortgage Brokers
  • Mortgage Underwriters
  • Investment Banks
  • Rating Agencies
  • Investors
  • Low mortgage interest rates
  • Low short-term interest rates
  • Relaxed standards for mortgage loans
  • Irrational exuberance
  • Alan Greenspan

But the four primary causes for the bursting of the housing bubble were:

  1. Low mortgage interest rates
  2. Low short-term interest rates
  3. Relaxed standards for mortgage loans
  4. Irrational exuberance

 

In the wake of the dot-com crash and the subsequent 2001–2002 recession the Federal Reserve dramatically lowered interest rates to historically low levels, from about 6.5% to just 1%. This spurred easy credit for banks to make loans. By 2006 the rates had moved up to 5.25% which lowered the demand and increased the monthly payments for adjustable rate mortgages. The resulting foreclosures increased supply, dropping housing prices further. Former Federal Reserve Board Chairman Alan Greenspan admitted that the housing bubble was “fundamentally engendered by the decline in real long-term interest rates.

Mortgages had been bundled together and sold on Wall Street to investors and other countries looking for a higher return than the 1% offered by Federal Reserve. The percentage of risky mortgages was increased while rating companies claimed they were all top-rated. Instead of the limited regions suffering the housing drop, it was felt around the world. The Congressmen who had pushed to create subprime loans now cited Wall Street and their rating companies for misleading these investors.

Low interest rates, high home prices, and flipping (or reselling homes to make a profit), effectively created an almost risk-free environment for lenders because risky or defaulted loans could be paid back by flipping homes.

Private lenders pushed subprime mortgages to capitalize on this, aided by greater market power for mortgage originators and less market power for mortgage securitizers, Subprime mortgages amounted to $35 billion (5% of total originations) in 1994, 9% in 1996, $160 billion (13%) in 1999 and $600 billion (20%) in 2006.

In March 2007, the United States’ subprime mortgage industry collapsed due to higher-than-expected home foreclosure rates (no verifying source), with more than 25 subprime lenders declaring bankruptcy, announcing significant losses, or putting themselves up for sale.

The first notable event signaling a possible financial crisis occurred in the United Kingdom on August 9, 2007, when BNP Paribas, citing “a complete evaporation of liquidity”, blocked withdrawals from three hedge funds. The significance of this event was not immediately recognized but soon led to a panic as investors and savers attempted to liquidate assets deposited in highly leveraged financial institutions.

The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. These losses are expected to top $2.8 trillion from 2007 to 2010.

In September 2008, the crisis hit its most critical stage. There was the equivalent of a bank run on the money market funds, which frequently invest in commercial paper issued by corporations to fund their operations and payrolls. Withdrawal from money markets were $144.5 billion during one week, versus $7.1 billion the week prior. This interrupted the ability of corporations to rollover (replace) their short-term debt. The U.S. government responded by extending insurance for money market accounts analogous to bank deposit insurance via a temporary guarantee  and with Federal Reserve programs to purchase commercial paper. The TED spread, an indicator of perceived credit risk in the general economy, spiked up in July 2007, remained volatile for a year, then spiked even higher in September 2008, reaching a record 4.65% on October 10, 2008.

The crisis rapidly developed and spread into a global economic shock, resulting in a number of European bank failures, declines in various stock indexes, and large reductions in the market value of equities and commodities.

The severe recession that began in December of 2007 was caused by the bursting of the housing bubble and the resulting credit crisis. Each of the four primary causes played an important role in creating the housing bubble and the credit crisis. The combination of all four causes created a type of “perfect storm” causing the housing bubble to be extreme and the resulting credit crisis to be severe. Three of the causes, though they contributed to the housing bubble, were not essential to the development of the bubble. Low mortgage interest rates, low short-term interest rates, and relaxed mortgage lending standards all contributed to the housing bubble. But the absence of any of these three causes would not necessarily have prevented the housing bubble. For example, if mortgage interest rates had not been at historically low levels, a housing bubble still could have happened. A housing bubble occurred in the late 1980s at much higher mortgage interest rates.

The one essential cause of the housing bubble was irrational exuberance. The housing bubble would not have occurred without the widespread belief that home prices would continue to rise. Irrational exuberance contributed to the other three causes. Mortgage interest rates would not have been so low if foreign investors and credit rating agencies had not believed that U.S. home prices would keep rising. Low short-term interest rates would not have led to such extensive use of ARMs and such a high degree of leveraging without irrational exuberance. And relaxed standards for mortgage loans would not have led to such a large increase in subprime mortgages without irrational exuberance.

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