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The Housing Crisis Of 2007 Term Paper


Executive Summary

The housing crisis of 2007 was the main cause of the 2007/2008 economic recession. It resulted from rise in subprime lending, ineffective government policies, and high-risk mortgages. Effects of the crisis included decline of the economy of the United States, Europe, and the world, and negative influence on financial markets. It affected every sector of the economy including labor markets, stock market, and financial institutions.

The government moved fast to alleviate effects of the crisis. Mitigation measures included creation of an economic stimulus program, introduction of Federal Reserve funds, and enactment of new legislation and programs. In other countries of the world, governments executed cuts on budget and government spending. However, despite stringent mitigation strategies, economies of many countries declined by large margins. Economies of developing and underdeveloped countries were the worst affected.

Introduction

In 2007, the United States of America experienced a severe downturn in the housing sector, an occurrence that caused panic and financial uncertainty around the world. The crisis was the main cause of the recession that began in 2008 and continued for several years. Several factors contributed to the housing crisis whose effects are still felt today. The subprime mortgage crisis was characterized by a drastic rise in subprime mortgages among borrowers, decline of mortgage-backed assets, and increase in mortgage foreclosures (Chukwuogor, 2012).

Results of the crisis were severe. Many financial institutions collapsed and led to reduction of amount of credit available to customers, thus kick starting the 2008 global recession. Several factors were attributed to the crisis. They included rise in subprime lending, government policies, speculations by homeowners, role of Fannie Mae and Freddie Mac enterprises, and high-risk mortgage loans (Moseley, 2011).

Causes of the crisis

Rise in subprime lending

The housing crisis began in the year 2006 owing to decline of the housing sector. In 2006, the housing bubble busted resulting to decline in securities associated with the housing sector. The government enacted policies that led to low mortgage rates, which increased the number of people that could access mortgages (Chukwuogor, 2012).

Rates of mortgages were very low in comparison to the risks they attracted. In addition, an increase in number of traditional mortgage incentives to investors resulted in high lending. Demand for mortgage loans started to rise from as early as the year 2006.

By the year 2007, demand was so high that standards of mortgage underwriting became compromised. As a result, many mortgage products were issued without legal documents to prove that borrowers were creditworthy (Chukwuogor, 2012). For example, the Adjustable Rate Mortgages were under very high demand during this period because lending requirements were flexible and affordable to many potential homeowners (Moseley, 2011). The high demand reflected a possibility of surge in house prices.

As a result, borrowers were given mortgages that they were expected to service in the long-term. On the other hand, increases in house prices stopped and house prices collapsed. Many borrowers failed to service their mortgages because they lacked financial ability to do so. Lenders ignored the fact that some borrowers were not creditworthy.

Government policies

In 1992, the government established the Housing and Community Development Act that facilitated home ownership for Americans (Moseley, 2011). The act mandated Fannie Mae and Freddie Mac enterprises to offer affordable loans to Americans to purchase homes.

The government authorized the Department of Housing and Urban Development to oversee issuance of loans by Fannie Mae and Freddie Mac. The act required that 30% of the companies’ total loans comprise housing loans. However, the department increased the requirement to 56% thus straining the finances of Fannie Mae and Freddie Mac (Chukwuogor, 2012). As a result, the companies developed a program to meet the new target.

They developed a program that involved purchasing $5 trillion housing loans. They thus encouraged lenders to relax loan issuance requirements to homeowners in order to meet their new target. Relaxation of lending requirements led to a surge in mortgage borrowing. To counter stiff competition, financial institutions offered high-risk mortgages to borrowers without documentation (Woellner, 2013). People with bad credit were able to access mortgages.

There was limited regulation of financial institutions prior to the housing crisis. Government regulations controlled depository banks but exempted investment banks whose high rate of lending led to the housing crisis. The 1982 Alternative Mortgage Transactions Parity Act (AMTPA) allowed investment banks to issue mortgages with adjustable rates (Moseley, 2011). The act was passed to make home ownership affordable.

On the other hand, the Glass-Steagall Act gave investment banks more freedom than depository banks on matters related to mortgage loans. Replacement of the Glass-Steagall Act with the Gramm-Leach-Bliley Act encouraged more risk-taking by investment banks regarding mortgage issuance (Moseley, 2011). The act increased issuance of high-risk mortgages by investment banks because of limited government regulation.

A 2004 decision by the Securities and Exchange Commission to change capital reserve calculation rules encouraged investment banks to increase their debt level thus enabling them issue more mortgage loans (Chukwuogor, 2012). As a result, the five largest investment banks in the US had accrued debt totaling to over $4 trillion by the year 2007. Investments banks had high ratios of debt to asset value, which increased risk of collapse and bankruptcy.

Before emergence of the crisis, the government had enacted several policies to advocate for affordable housing. The Community Reinvestment Act (CRA) of 1977 was passed to stop the act of discriminatory lending by banks. In 1995, the government added guidelines to the act that encouraged flexibility in lending.

Investment banks interpreted the additions as allowing relaxed lending regulations. They assumed that the government would not sanction them easily (Moseley, 2011). As a result, investment banks started to issue mortgage loans to unworthy borrowers resulting in bad loans that were never repaid.

High-risk mortgage loans

One of the causes of the housing crisis was issuance of high-risk mortgage loans to borrowers by lenders. Lenders offered loans to borrowers who had no means of repaying (Chukwuogor, 2012). In addition, high-risk borrowers such as immigrants and unemployed Americans had access to mortgages.

On the other hand, lenders offered several borrowing incentives that encouraged more borrowing. For example, many borrowers accessed mortgages without any down payment. In other cases, down payment requirement was 2%. Relaxation of lending requirements further aggravated the situation. Lenders only needed proof of money in order to issue mortgages. Documentation was not necessary and many people took advantage of lax requirements to access mortgages.

Impact of the housing crisis

Impact on the united states

The housing crisis had severe impact on the economies of the United States and the world. It led to near-collapse of the economy of the United States. Americans lost about 25% of their net worth owing to effects of the housing crisis. In 2008, the stock market index declined by 45% and house prices dropped by 20% (Financial Crisis Inquiry Commission, 2011).

Total home equity declined by $ 5 trillion in 2008 and total value of retirement assets declined by 22% putting retirees at risk of severe financial constraints. Pension securities declined in value by $1.3 trillion while savings and investment securities’ value declined by $ 1.2 trillion (Moseley, 2011). The GDP declined greatly and unemployment rates rose to 10% in 2009.

The number of unemployed Americas rose to 15 million in 2009. In the same year, house prices dropped by 30%. The stock market nearly collapsed and the wealth of American households and non-profit organizations declined by $ 15 trillion (Moseley, 2011). The crisis affected all sectors of the economy.

Impact on Europe

In Europe, the crisis led to increase in sovereign debt and inefficiency of the banking system (Woellner, 2013). To counter the effects, many European countries cut government spending and reduced government debt. For example, countries such as Greece, France, Portugal, Spain, and Italy executed significant budget cuts that matched their GDPs that were reflections of severe effects of the US housing crisis.

Despite cuts on spending, many European countries’ economies declined and rates of unemployment soared. For example, unemployment rates in Spain, Portugal, and the United Kingdom soared because their economies could not support the high financial requirements of labor markets (Financial Crisis Inquiry Commission, 2011).

Impact on financial markets

The crisis had severe effects on financial markets because it led to collapse of many financial institutions. In 2007, more than 100 mortgage companies halted their services owing to bankruptcy or severe financial constraints (Financial Crisis Inquiry Commission, 2011).

Many CEOs of financial institutions resigned and many financial institutions either collapsed or formed partnerships with other institutions. In 2008, investor panic led to withdrawal of money from investments that were directly linked to mortgage securities and equities. The crisis also led to high food and oil prices on the international market that affected many countries around the world. In 2008, big financial institutions such as the Lehman brothers collapsed as the crisis intensified.

In September 2008, investors withdrew more than $ 150 billion from money funds due to intense investor panic that increased uncertainty in the financial markets (Financial Crisis Inquiry Commission, 2011). The most severely affected countries were the developing and underdeveloped countries whose economies could not withstand the recession that resulted from the housing crisis.

Response to the crisis

Economic Stimulus Act

The Congress and President Bush enacted the Economic stimulus Act of 2008. The $152 billion fiscal policy was designed to help revamp the economy. It consisted of tax refunds to low income and middle class Americans amounting to $600 billion (Financial Crisis Inquiry Commission, 2011). In addition, laws governing businesses were also adjusted and improved. The American Recovery and Reinvestment Act of 2009 encompassed several measures that were directed towards changing laws governing businesses to help revive the economy. This included $787 billion that comprised expenditures from tax refunds and refunds from business investments (Financial Crisis Inquiry Commission, 2011).

Federal Reserve funds

The government introduced Federal Reserve funds as a quick remedy to the crisis (Financial Crisis Inquiry Commission, 2011). The plan was developed and implemented by the director of the Federal Reserve. The Federal Reserve also lowered short-term interest rates to a near-zero index (Woellner, 2013).

In addition, the Fed accumulated about $2 trillion in government debt and securities related to mortgages to lower interest rates further. This was in an attempt to revive the failed housing sector. Moreover, the Federal Reserve issued emergency loans on asset purchase that amounted to about $7.8 trillion (Woellner, 2013). In January 2012, the Fed announced a policy whose aim was to raise interest rates by the year 2014. However, the policy would be enacted after considerable recovery of the economy.

New legislation and programs

The government passed the Emergency Economic Stabilization Act of 2008 (EESA) that included a $ 700 billion fund (Woellner, 2013). The money was used for the Troubled Assets Relief program (TARP) that gave loans to banks as a revival strategy.

The Public-Private Partnership Investment Program comprised government incentives meant to lure stakeholders in the private sector into purchasing assets from banks that were on the verge of collapsing (Woellner, 2013). In addition, the government developed programs to bailout banks that were nearly collapsing. Many investment banks filed for bankruptcy while others went under receivership. On the other hand, few banks were taken over by stable financial institutions.

Conclusion

The 2007 housing crisis caused panic among investors and led to the 2007/2008 economic recession. Causes of the crisis included rise in subprime lending, government policies, and high-risk mortgage loans. Decline of the housing sector resulted from several factors.

The housing sector market became so rigid that investors could not quickly sell houses to make profits. Mortgage rates inflated and mortgages were no longer available for take up by homeowners. Many people defaulted to service their mortgages and this left financial institutions reeling in loses.

This led to great loses in investments that were backed by mortgages. In addition, it resulted in availability of many houses in the market resulting in low prices that put many house investors and builders out of business.

Measures to alleviate effects of the crisis included passage of new legislation and policies, creation of an economic stimulus program, and introduction of Federal Reserve funds. Effects of the housing crisis led to widespread unemployment, collapse of financial institutions and businesses and led to the decline of the economy.

References

Chukwuogor, C. (2012). The U.S Financial Crisis and Economic Recession 2007-2010: Causes, Local and Global Implications, Actions Taken, and the way Forward. Philadelphia: Global Business Investments & Publications LLC.

Financial Crisis Inquiry Commission: The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States (Revised Corrected Copy). (2011). New York: Government Printing Office.

Moseley, F. (2011). The U.S. Economic Crisis: Causes and Solutions. Retrieved from

Woellner, J. (2013). The US Mortgage Crisis at the Beginning of this Millennium. New York: GRIN Verlag.

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