Introduction
Investment destination is a major consideration amongst the investors. Selection of the most viable industry to invest in requires the investor to conduct a comprehensive analysis of the various environmental factors. This will help in the determination of the feasibility of investment. The various types of investments can either be long term or short term. Housing is amongst the most viable long term investment destinations. In America, the housing industry has been stable for approximately fifteen years.
Currently, a serious slump is being experienced within Americas housing market. The slump which is characterized by a drop in the housing price has been in existence from 2005 to 2006. The 2007 financial crisis has made the slump in prices to worse. According to the US Department of Commerce, there was a reduction with regard to the housing construction industry. By January 2009, house construction declined with a margin of 14.3%. This resulted to a fall in the housing price by a half within the countries major housing markets. Amongst the states that have experienced a steep fall in the price of housing include Virginia, Florida, California and Arizona (Mike, 2007, ¶1). The discussion of this paper seeks to explain the causes and effects of housing market crash in America.
Causes of crash in the housing market
Aggressiveness in the sale of subprime mortgages
The housing industry has for a long time been considered as low risk investment sector. This resulted into a general perception amongst the investors in relation to the real estate being the safest vehicle to safeguard their money. This caused an increase in the number of institutional and individual investors venturing this investment vehicle from 1990 to 2005. Amongst the institutional investors included the financial institutions such as the banks (Puneet, 2009, ¶3).
As more individual investors ventured the real estate sector, there was an increase in demand for finances. Considering the low risk perception of the housing sector, the financial institutions increased their subprime mortgage lending by five to ten times which was more than the earning capacity of the people. Subprime mortgage is a loan that is lend to the individuals with a low credit rating and cannot qualify for the conventional mortgage. The objective of the increasing their lending level to these investors was to maintain their level of sales. This was beyond the predetermined safe range of three to four times. In their lending process the financial institutions were not conducting a comprehensive scrutiny of the ability of the investors to repay the mortgage. Amongst the investors that these firms financed had a low credit rating and a low level of income. There was also no requirement of any down payment and hence higher chances of default. This resulted into an increase in the cash flow within the housing industry culminating into an inflationary effect to the housing prices.
Increased use of adjustable mortgages
By the beginning of 2002, the interest rate in the housing market was very favorable at 1%. The adjustable mortgages’ enables the mortgagee’s payment to be initially low. The low interest rate made the mortgages to be very attractive. More individuals could afford to secure a mortgage. However, a reverse of this trend of low interest has been experienced in the recent past with the interest rate increasing. This affected the housing market through an increase in the mortgage payment. The increase in the cost of mortgage repayment affected the low income families. This is due to the fact that they could not be able to repay the mortgage resulting into a crash of the mortgage financing institutions.
On the other hand, there has been increased promotion of the discounted mortgages within the housing industry. Discounted mortgage enables the mortgage payment to be relatively low for the first two years. Later, the cost of the mortgage is adjusted to the standard rate. During the introductory phase, the mortgage financing institutions do not clearly explain all the details pertaining to the mortgage to the mortgagees. By the end of 2007, most of the individuals were through with the introductory period. After the introductory period, the cost of mortgage increases making most of the mortgagees unable to pay since they were on the lower income bracket. This resulted into a crash in the housing market.
Increase in the interest rate
In 2002, the US government loosened its monetary policy. The cause of loosening the monetary policy was due to the weakness that was being experienced in the various sectors of the economy. The loosening of the monetary policy would result into stimulation of the rate of economic growth. However, the long term effects of loose monetary policy on the housing industry were not considered. Most of the individuals who purchase homes require loans (mortgages).The low interest rate enabled the low income earners to be in a position to own a house.
The low interest rates have an inflationary effect within the housing industry. In the recent past, the interest rate has increased from a low of 1% to a high of 5%. This has increased the cost of the mortgage payments significantly. For example, according to research, a rise in interest rate by 2% resulted into an increase in the cost of mortgage payment by 40% (‘Boom, bust and busting bubbles’, 2009, ¶6).
Increased speculation within the housing industry
Speculation refers to the concept where investors invest capital in various avenues not necessarily to gain through income generation from this investment but from expectation of future changes in prices. Speculation has a high element of risk in relation to the various economic sectors. This is due to the fact that it can result into a boom followed by a crash. In the recent past, the US housing industry has experienced a high level of speculation. This resulted from the fact that there was a significant increase in the house prices. For example, of all the house purchases in US during 2005, 25% of them were as a result of increased speculation. This is due to the fact that the returns from the housing industry were much higher than that from the stock market. This presented a feasible investment opportunity for the buy-let investors. In the event of the housing prices falling, the housing sector is significantly affected.
Effects of US house market crash
Effect on the Gross Domestic Product
According to Mike (2007), there is a possibility that the crash that is experienced within the US housing industry will plunge US into a second economic depression (¶3). This is due to the fact that there will be a reduction in the country’s Gross Domestic Product (GDP) due to the slow growth rate. The reduction in the countries GDP will result from an increase in the level of unemployment within the country.
The crash in the housing market will increase the level of unemployment in various ways. The housing industry will be directly affected due to the reduction in home constructions and the number of home sales. Other sectors related to home building such as hardware firms, furniture firms, real estate agents, mortgage brokerage firms will also be affected. According to this survey, an estimated 10,000 to 12,000 individuals will be laid off. This will culminate into a reduction in the level of consumers spending due to the effect of unemployment on the consumer’s level of wealth.
The effect is that the economic recovery from the current financial crisis will take longer. This is due to the fact that the housing industry is a major contributor to the country’s GDP. For example, according to Mike (2007), the recent increase in the home values enabled the individual homeowners to use their property as Automated Teller Machines (ATMs) through withdrawals of the mortgage equity. This has resulted into an annual increase of 2% in the level of the country’s GDP for the last five years. The current crash within the housing market will result into an evaporation of this effect on the GDP (¶12).
Social divisions
The US government is formulating a policy of revamping the US housing market by lowering the interest rate. This will result into creation of a housing bubble. Upon this bubble deflating in the future, most of the Americans (especially the working class) will have huge loans to pay. The value of these loans will be relatively higher than the value of their mortgaged homes resulting into creation of social divisions.
Increase in foreclosures
The crash in the US housing market has resulted into an increase in the number of foreclosures. Foreclosure refers to the process through which the property under mortgage becomes legally owned by the mortgagee with out the capacity of the mortgagor redeeming it. Foreclosure mainly arises from the failure of the mortgagee to make the payments (Mike, 2009, ¶7). The increase in foreclosures resulted from the increased number of mortgages that were issued by the financial institutions to individuals who could not be able to repay. The increase in the number of foreclosures in US has resulted into a negative financial effect to the US government. This is due to the fact that the government has to bail out the financial institutions from the looming massive loss. In order to do this, the American government will utilize trillion of dollars. This means that there will be an increase and a diversion in government expenditure. This is due to the fact that the government will have to use the taxpayers’ money to bail out the banks from the losses resulting from their mortgage investments (Mike, 2009, ¶8).
On the other hand the increase in the number of foreclosures in the housing market will result into a further reduction in the value of homes. There will also be a reduction in the annual rate of home construction in US from 2,000,000. Currently, the rate of home construction is at 1,400,000 with expectations of further drop to a level below 1,000,000 in the near future (John, 2007, ¶13).
Conclusion
The US housing market has experienced a significant slump in the recent past. This has resulted from a number of factors. The increase in demand amongst the investors to venture the housing industry increased the demand for finances. This resulted into an increase in the sale of subprime mortgages by the financial institutions. More individuals could be able to own a home. This resulted into an increase in cash flow within the housing market culminating into an increase in the price of the homes. The housing market crash resulted from the inability of the individuals to make the mortgage repayment. There was also an increase in the use adjustable mortgages together with the promotion of the discounted mortgages amongst the financial institutions. The adjusted mortgages enabled the individuals to easily obtain the finances to secure a mortgage. The rate of interest was relatively low in the introductory stage but increased later. This increased the cost of the mortgage for the low income earners resulting into an increase in loan default rate. The loosening of the monetary policy by the government in relation to the interest rate resulted into ability of low income earners to secure the mortgage. In the future, there was an increase in the rate of interest thus increasing the cost of the mortgage. The crash of the housing market also resulted from increased speculation which created a bubble within the US housing industry.
The crash within the US housing market will result into negative effects within the economy. The country’s GDP will reduce. This is due to the increase in the rate of unemployment reducing the consumer spending. There will also be creation of social divisions due to the huge loan burdens resulting from the inability of individuals to make mortgage repayment. This will also result into a reduction in the annual home construction rate. The increase in mortgage default rate will result into an increase in government spending in its effort to bail out the financial institutions. There will also be an increase in the number of foreclosures.
Reference list
Building communities. (2009). “Booms, bursts and bursting bubbles: what the housing crisis means to South Carolina.” Carolina: East Carolina University. Web.
John, M. (2007). “Housing market impact on the US economy: should the Fed cut the interest rates?”The market oracle.
Mike, W. (2007). “US housing market crash to result in the second great depression.”The market oracle.
Puneet, K. (2009). “Housing market crash in North America.”Enzine articles.
Talbott,J.R. (2003). The coming crash in the housing market: 10 things you can do now to protect your most valuable investment. McGraw-Hill: McGraw-Hill publishers. Web.