House prices in the United States rose by almost sixty percent between 2000 and 2006, before their decline in 2007. The rise in prices was mainly due to a robust growth in demand for housing along with scarce supple because of a shortage in availability of land, mostly in the urban areas, and possibly, fragile competition in the construction segment. Furthermore, demand for housing was stimulated by some unsustainable elements, including excessive expectations regarding increase in house prices, easier access specifically to the mortgage loans, and accommodative monetary policy.
It is, therefore, necessary to understand what is meant by the housing bubble. “A bubble is like a gold rush — lots of people trying to make a quick buck by betting that something is going to be valuable”, says Frank Ahrens of the New York Post. Bubbles happen when the price for the item is much higher than what it should actually be. Typically, housing prices are about 4 times a person’s disposable income. In 2006, right before the housing bubble popped, houses were selling at 5.2 times a person’s disposable income. (Ahrens) As a balloon is blown up, it keeps expanding to allow for more air. Eventually, the balloon cannot hold any more air and it explodes. This is what happened to the real estate market; prices continuously increased; however, it has now stopped. The housing balloon could not hold anymore air and it popped.
Main Players in the Housing Market
It is pertinent to mention that agents are actually trained to put home buyers into the most expensive home they can afford. There is a reason for this. For just a relatively small amount of additional payment, a homebuyer can usually get a much larger home. Real estate agents are paid on commission. As the price of the home increases, so does the amount of money that the agent receives in commission, this is where the agent’s greed comes into play. If one property is going to make a real estate agent more money that another, it is easy to understand the direction followed by the agent. Could it possibly be that agents encouraged stretching the limits of affordability in order to make more money. So, are the greedy real estate agents to blame? They could be, but they had help.
There is another player in this that needs exploration, the mortgage lenders. During the years preceding the bubble burst, there was widespread marketing of risky, low “teaser” rate mortgages. Some of these “teaser” mortgages had adjustable rate mortgages with low to no initial interest rates were used to lure potential homebuyers into the lenders office. They were then shown how to afford the house they have always dreamed of. Because these loans were calculated using these introductory rate, people were able to qualify to purchase their dream home. However, the phenomenon of affordability of owning dream houses should have also been considered. The trick to these loans was that they were only at these low to no interest rates for a short period of time. Once the initial time was up, the repayments jumped up to unaffordable rates, and their dream homes became a nightmare for them. Even though, there are disclosures that are supposed to explain the terms of the loans were, these statements were not explained to nor understood by the home purchaser.
Context of the Real Estate Housing Bubble
Nominal house prices in the Untied States started falling in the middle of 2007. This phenomenon was not experienced since World War II. The fall in real state housing prices followed a huge increase in prices during 2001-2006. This unexpected rise was, in fact, exceptional not only in scale but also in its country-wide scope. The variation of prices was witnessed among regions. The price trend particularly in rural areas is significantly distinguishable compared with the urban areas. It has been observed that real estate housing prices remained relatively stable, while in urban areas they seemed to show a long-term increasing trend along with huge volatility.
The difference basically stems from the features of the supply side in housing sector. Rural areas present practically unlimited scope as well as opportunity for new construction. In the long run, real estate housing prices ought to increase not more than cost of construction. On the contrary, in urban areas, the supply forces in housing sector are mostly constrained. This, in fact, means that demand in the real estate housing market is the major determinant of prices. House prices, particularly at the national level, can be considered as the determinants in the rural and urban areas and by the relative significance of these areas. The differentiation between rural and urban areas should be considered while modeling prices in real estate housing sector. As such, at the national level, house prices are assumed to be expressed as a prices’ weighted average in such areas in which housing supply is restricted and prices in those areas where supply is not restricted- the rural areas.
Causes of Real Estate Housing Bubble
The real estate housing bubble was caused by easy access to mortgage lending, accommodative and adjustable monetary policy, and extreme anticipations of rise in prices. Many factors force rising demand for housing between the later half of 1990s and year 2006. During same time, forces of supply were not capable of making adjustments with the surging demand in cities, or were much slower in rural areas. Governments of the United States, from 1992 onwards, increasingly relaxed their policies related to mortgage lending for encouraging home ownership. Studies have estimated the fact that house prices were almost overvalued by thirty percent in the year 2006, considered as the height of the real estate bubble.
Furthermore, the overall development of mortgage lending facilitated lenders for providing easy access to loans to households who offered weak financial guarantees against such loans. Resource to securitization has, in fact, allowed lenders to lay off some of the risks related with such loans. Expectations regarding variations in house prices played a major role in the real estate market where most of the players comprised private persons. Property, indeed, came to be viewed as a place of safety after the crisis of stock market crash in 2001, mainly due to the widely accepted thinking that house prices in United States could not decline. This was the context to the increasing scale of real estate buying for the purpose of speculation. Expectations regarding rise in real estate prices motivated lenders to relax their terms and conditions of lending on the hypothesis that a household is always in a position for selling the mortgaged property if there are chances of default in repayment schedule. (Roberts 185)
Interest rates were sharply lowered by FED reciprocating to the recession at the start of this decade. Resultantly, rate of FED Funds declined from 6.5% at the end of year 2001 to 1% in 2003. Along with functioning of different other elements, monetary policy facilitated in sustaining mortgage rates at much lower level. Furthermore, this extended period during which monetary policy was highly responsive and accommodative created a scenario of abundance in liquidity to support the supply of mortgage lending.
Another phenomenon in creating real estate housing bubble was that supply has not made adjustments properly with the rising demand especially for housing in cities ultimately leading to increased prices, given the rigidness of supply. Housing supply in rural areas appeared to follow cost of construction specifically in the long-run. However, from the middle of the decade of 1990s, prices rose much faster compared with these costs. In the same period, profits of construction firms rose sharply in relation with the long-term and also to the remaining private sector. This indicated the fact that supply had inappropriately adjusted to robust housing demand, consequently allowing increase in margins.
The inflated profits remained high for almost a decade which indicated a particular lack of competition in the real estate and construction industry. Moreover, there was no considerable development in the number of startups in the construction area during this period. However, prices could continue to fall, dropping below their equilibrium point, mainly due to the increasing number of foreclosures or due to the vanishing of several players from the mortgage market which is responsible to decrease in demand for mortgage financing over the next few years. It is expected that the fall in price level will impact economic activities, such as reducing inflation, and also to have an influence on the overall financial system. Any decrease in the house prices would result in discouraging the construction segment and also impact household consumption through withdrawal in mortgage equity and property wealth impacts. This may decrease consumption level by an almost one percent, in over two years. (Stolberg)
Real Estate Housing Bubble and Global Credit Crunch
The real estate housing bubble resulted in creating global credit crunch, the impact of which spread throughout the world. Despite coordinated, drastic and dramatic cuts in interest rates, huge cash infusions and nationalization of banks, the credit across the world remains crunched and most of the financial infrastructure is confronting the challenge of collapse. Almost every nation in the world is facing the challenge of global credit crunch. The credit crunch, in fact, commenced in the American Mortgage markets. It is pertinent to highlight the relation between crash of mortgage market and the global credit crunch. Home buyers seek loan or money from Bank as well as Non Bank Lenders who in turn borrow from International Bank Lenders and Mortgage Funds.
The Non Bank and Bank lenders utilized this borrowed money for granting loans to home buyers. A general phenomenon developed for the last few years signifies that only some of those loan recipients or home buyers paid back Bank and Non Bank lenders. For the last few years, the mortgage lending market of United States has been much relaxed, as such there were no proper credit checks placed as previously done resulting in huge and unexpected defaults. Ultimately the International Bank Lenders as well as trusts were not paid or payment of all credit was not made to the global credit market resulting in a huge global credit crunch. Non Bank Lenders and Banks from across the world access similar credit pool- as such they are confronting a crunch- known as ‘global credit crunch.’ (Smith)
Support of Stimulus Bill to Real Estate Market
President Barack Obama has signed the US$ 787 billion stimulus bill or the ‘American Recovery and Reinvestment Act of 2009’ into law. The debatable issue has emerged is; will this bill or policy stimulus work? It is believed by the proponents of bill that the combination of huge fiscal stimulus, a massive and comprehensive plan to address the financial system, and the continuous monetary ease will support to promote a gigantic return to positive growth in United States in the later half of 2009. (Droke 101)
In the stimulus bill there is a tax credit of fifteen thousand dollars for homebuyers. This is entirely new credit that will result in doubling the old credit of seven thousand and five hundred dollars. Moreover, this new version of the tax credit for homebuyers would be for any type of homebuyers and not only for first time homebuyers. Another significant feature of the stimulus bill is ‘moratorium on foreclosures’. Its focus is on forestalling foreclosures. A ninety moratorium would be applied, with the expectation that mortgage lenders as well as borrowers could work out entirely new terms specifically for loan modifications. This is also aimed to support those who have lost their jobs so they can shun foreclosure till they are reemployed. These new additions in the stimulus bill could support in stimulating the real estate market. If the buyers can avail a tax credit along with a very low rate of interest, there could be a firm chance for them to by a home. Moreover, the moratorium foreclosing could stave off expected defaults. (Abrams)
However, the other side of debate is that such measures will have insignificant impact delaying the inevitable. There is also a skepticism related to the overall effectiveness of a mortgage moratorium, and a grave concern that the measures taken to tempt homebuyers will ultimately end up in problems particularly in the long-run. In fact, tax credit for purchasing home is raising the hopes and increasing expectations of real-estate industry.
Works Cited
Abrams “Meltdown 101: Highlights of economic stimulus plan”. Yahoo News, 2009. Web.
Ahrens, Frank , “What do Terms ‘Bubble, “Crash’ Really Mean?” Washington Post, The Newspaper Source. EBSCO, Solano College Library, Fairfield, CA. 2009. Web.
Droke, Clif America’s Housing Bubble: The Real Estate Outlook for 2006-2012 Publishing Concepts, 2005, p. 101.
Roberts, Lawrence, The Great Housing Bubble: Why Did House Prices Fall? Monterey Cypress, 2008, p. 185.
Smith, “The Credit Crunch is Dead! Long Live the Credit Crunch. Credit markets,” Economic fundamentals Social Europe Journal, 2008.
Stolberg, “Obama signs stimulus bill as parties jockey over implications”. Herald Tribune, 2009. Web.