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What was the single most important reason why the bursting of the US housing bubble in 2008 turned into a global financial crisis? Essay Example

Single most important reason why the busting of the US housing bubble and bust turned into a global financial crisis

Introduction

The 2007-2009 recession was the second most severe after the Global Depression of 1930s (Helleiner, 2011, p.68). Lin & Treichel (2012, p.3) observe that it is difficult to pinpoint the precise cause of the global crisis experienced in 2007-2009. However, Beachy (2012, p.8-13); Baker (2008, p.73) observes that the principal contributor to global recession in 2008-2009 is the housing bubble and bust in US as a result of low interest policy in 2001 by Federal Reserve. The development of US housing bubble and bust is first attributed to the internal factor of US financial regulation & monetary policy or the domestic factors. Secondly, it is attributed to the external international factor of global imbalances as a result of glut of savings moving from surplus economies to deficit countries (see for example Lin & Treichel, 2012, p.23; Verick & Islam, 2010, p.13). As such, the purpose of the paper is to determine the single most important reason why the busting of the US housing bubble and bust turned into a global financial crisis. The paper argues that the most plausible reason why the busting of the US housing bubble in 2008 turned into a global financial crisis is as a result of internal factors associated with the loose monetary policy, politics of market & regulatory failure.

The Housing Bubble & Bust

The housing bubble, in US is related to the sharp rise of housing prices and the subsequent rapid fall of the same prices (Cohen, Coughlin & Lopez, 2012, p.341). Levitin & Wachter (2011, p.1) indicate that the in the period of 1997 to 2006, the US housing prices had shot up by 188%. However, by the mid 2009, the housing prices had declined by 33% from the crest. Bubble scenario is necessitated when ‘trade is in high volumes that are considerably at variance with intrinsic values’ (Byun, 2010, p.4). The housing bubble in US emerged in mid 1990s just as stock bubbles and thus, giving birth to consumption boom. The impact of 2001 recession saw reduction of interest rates, hence pushing federal funds rate to 0,1 percent in the summer of 2003 (Baker, 2008, p.73-74).

Letvin & Wachter (2012, p.1178) observe that the bubble occurred as a result of monetary policy geared towards encouraging affordable housing created a supply oriented phenomenon that gave birth to mispriced mortgage finance. As the emergence of mispriced mortgages ensued, finance spreads dramatically reduced and the volume increased while the risk increased. As such the finance supply gut occurred as result of the premise that markets were unable to price risk correctly owing to the complexity and heterogeneity of the private-label mortgage backed securities (MBS). These MBS worsen or aggravated informational asymmetries between MBS investor and the financial institutions. The end result was an over investment in MBS that enhanced the financial intermediaries profits and empowered borrowers to bid up housing prices.

Byun (2010, p.3) opines that by the late 2005, the exponential growth that had characterised the US housing market had reached a lag phase and staring at a bust. For instance, during the bust period, first-time home buyers were being displaced out of the market as mortgage rates grew approximately by 1 percent. As such the affordability of the homes reduced significantly and speculators opted out of the market. The impact of such was the growth of ‘2-28’ mortgages and ‘Alt-A’ mortgage category that is common in subprime properties. These were loans of objectionable quality as they were considered ‘liar loan’ as most were issued with incomplete portfolio (Baker, 2008, p.76).

Causes of US Housing Bubble, Bust and the most Plausible Option

Most literatures revolving around the global recession of 2008 points out that there is varied interpretation on the exact causes of housing bubble and bust in US and the subsequent economic and financial crisis. Lin & Treichel (2012, p.23) posits that the US housing bubble is principally as result of two domains. These include global imbalances & internal policy issues. For instance, Levitin & Wachter (2012, p.1777) observes that the internal policy issues that encouraged housing bubble was as a result of misguided monetary policy; government policies encouraging affordable housing prices and inelastic housing supply. The same argument fronted by Lin & Treichel (2012) is affirmed by Verick & Islam (2010, p.13) who notes that the significant contributors to the US housing bubble include external international factor such as global imbalances and internal factors such as interest rates, perceptions of risks and regulation of the financial system. See figure 1 below for a diagrammatic representation of the causes of US housing bubble.

As such, the emerging observation is that the causes of US housing bubble can either be categorised as external international factors that operated outside the boundaries of US economy, but highly impacted on the internal operations of US economy. Such argument is affirmed by Lin & Treichel (2012, p.3) who notes that the primary cause of the global crisis is the global imbalances. The argument is that East Asian economies especially China contributed to the global imbalance. The rationale is anchored on the fact that most are premised on export-led growth strategy. This was necessitated by urge to accumulate international reserves so as to curtail repeat of 1998 balance of payment crises. This ensured global saving glut that brought about low world interest rates, unbridled growth in the financial sector and finally the housing bubble that exponentially ushered the global recession (p.24).

On the other hand, there are those who see the global imbalance not as a cause, but as a facilitating factor. In their argument, their core contention is that the internal factors associated with the loose monetary policy, politics of market & regulatory failure are the principal culprit in US housing bubble. This is critically linked to the urge to address income inequality in US with the response being ‘political expediency of granting increased mortgage access’ (Beachy, 2012, p.42-43).This is embodied in the booming NASDAQ in 1998 -2000 and reduction of policy interest rate/ easing by Federal Reserve in 2001 (Verick & Islam, 2010, p.14; McKibbin & Stoeckel, 2010, p.58). Such internal loose monetary policy resulted in ripple effects such as subprime lending & increase in interest rates (Helleiner, 2011, p.68; Jones, 2009, p.5). Equally, it necessitated rising housing prices and myopic risk taking by banks & CEOs whose pay was performance-based (Beachy, 2012, 45-51).

Out of the two propositions and how they connect to the ultimate concern which is subprime mortgage crisis, the internal factors associated with the loose monetary policy, politics of market & regulatory failure presents the most plausible option in explaining the housing bubble in US. The rationale is anchored on the premise that it constitutes a response to curtail the income disparity through mortgages that ushered in a trend which under-qualified individuals were encouraged to borrow by the Federal Government. To attain such policy the Federal Chair reduced Federal Funds rate from 6.25 percent to 1.75 percent in 2002 and ultimately to its lowest of 1 percent in 2003. This lead to excessive liquidity & growth of humongous demand bubble thus, distorting interest rates, asset prices, diverted loan-able funds into wrong investment options and converted the robust financial institutions into unsustainable positions (White, 2009, p.2-3). As such, the subsequent discussion chapter explores how the monetary policy, politics of market & regulatory failure demarcated by unusual monetary policy moves, unwise regulations, and misguided federal housing policies contributed to housing bubble in US and ultimately the global recession.

Figure 1:Explaining the key factors behind the global financial crisis

What was the single most important reason why the bursting of the US housing bubble in 2008 turned into a global financial crisis?

Source: Verick & Islam, 2010, p.14

Discussion

While there are varied views about the cause of housing bubble in US and subsequent global economic & financial crisis, the loose monetary policy, market politics and regulations emerges as the most direct cause to the housing bubble in US. The role of inadequate monetary and housing policy in ensuring housing bubble and bust rests on the fact that most jobs are directly linked to the value of housing through spending by household and public sector (Cohen, Coughlin & Lopez, 2012, p.341). The rationale is premised on the realisation that such lacuna and performance gaps in monetary policies at the national level led to deterioration in lending standards and shooting up of housing prices. Equally, such structural adjustments lead to changes to the mortgage market institutional structure and mortgage lending to individuals who are less credit worthy (Levitin & Wachter, 2011, p.1-2).

Indeed the contribution of cheap monetary policy of expanding Federal Reserve Credit that can be described as ‘unusual monetary policy, unwise regulation & misguided federal housing policy’ lead to increased risky mortgages. For instance, by 2006, the non prime share of new mortgages had grown to approximately 34 percent. This brought non prime share of existing mortgages to 23 percent (White, 2009, p.3). the sub-prime meltdown was characterised by household borrowing from the originator. This implied that brokers did not understand the credit worthiness of the borrowers. Secondly, originator sold the mortgages to another financial institution. This gave birth to perverse incentives. Thirdly, financial institutions issued mortgage-backed securities (MBS). This allowed for greater leverage. Finally, the process was demarcated by collateralised debt obligations (CDOs) issued by private financial institutions (Verick & Islam, 2010, p.18).

Cohen, Coughlin & Lopez (2012, p.346) contextualises the whole debate in a summarised form by observing that during the bust there was large increase in ‘distressed sale’. Distressed sales are composed primarily of ‘short sales’ and ‘REOs’. Short sales result from a decline in housing prices, which leaves many homeowners with mortgage debts larger than the value of their homes -‘underwater’. When these houses are sold, the proceed fall ‘short’ of the balance owed on the property’s loan. Meanwhile, REOs are real estate properties that are owned by the lender rather than the borrower and are frequently acquired through a foreclosure. For various reasons, such as poor maintenance and vandalism, the downward price pressures on distressed sales tend to be larger than on other sales. Such sales also have a negative impact on the values of nearby homes.

Conclusion

The aim of the paper was to establish the single most important reason why the busting of the US housing bubble in 2008 turned into a global financial crisis. The article found out that there are numerous propositions that seeks to explain why the busting of the US housing bubble in 2008 turned into a global financial crisis. In this regard, the paper determined that the cause are broadly categorised into two domains. The first is the external international factor associated with the global imbalance associated with the East Asian economies that were keen to accumulate international reserves leading to surplus in their countries and deprivation in countries such as US. In this paradigm, global imbalance is seen as not the primary cause, but as a necessitating factor. On the other hand, the article argues that the single most cause of housing bubble in US is as result of the internal monetary policy pursued by the Federal Government to bridge the income gap between low-income earners and the medium-high income earners which resulted into alteration of interest rates, asset prices, re-routing of loan-able funds into wrong investment options and limited the once robust financial institutions into unsustainable entities. As such the later is treated as the most plausible and direct cause and not necessitating factor.

References

Baker, D. (2008). The housing bubble and the financial crisis. Real-world economics review, 46, 73-81.

Beachy, B. (2012). A Financial Crisis Manual: Causes, Consequences, and Lessons of the Financial Crisis. Global Development and Environment Institute Working Paper No. 12- 06. Available at: http://www.ase.tufts.edu/gdae/Pubs/wp/12- 06BeachyFinancialCrisis.pdf.

Byun, K. J. (2010). The US housing bubble and bust: impacts on employment. Monthly Labor Review, 133(12).

Cohen, J. P., Coughlin, C. C., & Lopez, D. A. (2012). The boom and bust of US housing prices from various geographic perspectives. Federal Reserve Bank of St. Louis Review, 94(September/October 2012).

Helleiner, E. (2011). Understanding the 2007-2008 global financial crisis: Lessons for scholars of international political economy. Annual Review of Political Science, 14, 67-87.

Jones, C. I. (2009). The Global Financial Crisis of 2007–20??. A Supplement to Macroeconomics, 1, 1-45.

LEVITIN, A. J., & WACHTER, S. M. (2011). The housing bubble. University of Pennsylvania Working Paper.

Levitin, A. J., & Wachter, S. M. (2012). Explaining the housing bubble. Georgetown Law Journal, 100(4), 1177-1258.

Lin, J. Y., & Treichel, V. (2012). The unexpected global financial crisis: researching its root cause. World Bank Policy Research Working Paper 5937. Available at: http://elibrary.worldbank.org/doi/pdf/10.1596/1813-9450-5937.

McKibbin, W. J., & Stoeckel, A. (2010). The Global Financial Crisis: Causes and Consequences*. Asian Economic Papers, 9(1), 54-86.

Verick, S., & Islam, I. (2010). The great recession of 2008-2009: causes, consequences and policy responses (No. 4934). Discussion paper series//Forschungsinstitut zur Zukunft der Arbeit.

White, L. H. (2009). Housing Finance and the 2008 Financial Crisis. The Cato Institute, August.