The Real Estate Housing Bubble

Published Date: 02 Nov 2017

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Introduction

The global financial crisis of 2008 is the worst financial crisis in terms of people affected and financial cost, since the Great Depression, which was experienced in the 1930’s. It began with the credit crunch in mid 2007 following loss of confidence in the US financial system. The crisis started with the bursting of the subprime mortgages bubble, collapse of financial institutions and bailout of companies by the government. In other studies, it is seen as a culmination of poor financial decisions and lack of proper supervision of the financial sector, including international trade imbalances, which had stated several years before the financial crisis in 2008. The crisis affected the global economy and was felt even in countries that were not directly hit by the housing bubble. Following the bailout, most companies have been able to recover, and even though the effect is still felt it is not as much as when the economy was hit in 2008.

Causes of the financial crises

There causes of the global financial crisis of 2008 are many and some interconnected. It is not one cause that should be taken as the cause of the financial crisis. Some of the causes may have been effect long before the actual crisis was experienced. Some of the financial crises are as discussed here.

The Real Estate Housing Bubble

About a decade before the financial crises, mortgage prices were increasing and most people, including investors and financial institution thought that the increase in housing prices would continue. They felt that this was a profitable area to invest in. This led to the development of new mortgage facilities; some not well thought out. There were no proper checks, and the mortgages were given to people who would not afford if proper vetting was done. They were also giving them to the high-risk borrowers who had a poor credit history. The interests would b below market rate for the first years and the rates would increase to market rates later. The whole mortgage underwriting process was flawed.

The prices of the houses started to fall, and the interest rates state d to rise. Many borrowers with the subprime loans found themselves unable to repay their mortgage installments. The borrowers then decided to sell off their mortgages. There was a problem for there was no one to sell to as most of the borrowers were experiencing similar difficulties. The banks were also in a crisis and they started panicking. The value of the houses was less than the loans that had been given out for the loans. Mortgage repayments was not being repaid, and there was no market for the reposed houses. Stockbrokers realized that the loans were not performing and pulled out their money, worsening the liquidity position of the banks. On the other hand, banks wanted to hoard money given the situation and the bad assets that they were holding. This made them stop lending even to the good customers, and so there was nowhere to get funding. This was the credit crunch.

International Trade Imbalances

Growing income inequality and wealth concentration, make household consumers unable to absorb all the local production. This makes the surplus savings unsustainable within the local economy and creates a need for speculative investments or exportation to other economies. This exporting of excess savings and less importing of foreign demand, brings about deep imbalances between international trade and capital flows, which results in global trade distortions. It is not that trade imbalances that cause financial crises per se, trade imbalances can be sustainable for years and not lead to crisis. A country with trade deficits for a long period with no domestic investments gets a rise in foreign capital inflows, the liabilities generated by the inflows with no associated increase in growth of domestic assets, cause foreign trade debts to rise and cause crisis. The cause of financial crises, therefore, was the trade policies in countries that have trade surpluses and those with trade deficits that were distorted and are unsustainable.

These trade imbalances maybe caused by changing relationship between consumption and GDP which is influenced by tariff and currency used as a form of trade intervention. This can also be caused by the relationship between trade, savings rate and international capital flows. Another cause is use of the role of US dollar as the global reserve currency, which makes it seem like global trade is dominated in US dollar, which is not, but just a trade policy in the foreign countries.

Trade imbalances can be summarized as financial capitalism and be described as the cause of the financial crisis. The increasing financial capitalism is causing deficits and debt differences, increasing the gap between wage and productivity growth between economies. The unresolved financial capitalism issues have contributed to the global financial crises.

Lehman Brothers

Lehman Brothers was the fourth largest investment bank by the time they filed for bankruptcy in 2008. Lehman had borrowed heavily for investment in the years preceding its bankruptcy, increasing its leverage ratio to a very risky position of about 31:1. Lehmann was also accused of falsifying audited accounts to give an image of a well performing company, whereas it was not doing well.

The subprime mortgage, which had started affecting the economy, also hit Lehman. The firm also reported losses in the first quarter of 2008 and their share prices dropped. All these factors culminated in filing for bankruptcy by Lehman. This was the greatest bankruptcy to ever be filed in the us and given the time that this was happening, when the financial crises was at its peak, this shed another bad signal and messed the already bad situation by causing more panic to the investors.

The financial crises was greatly affected by the Lehman brother case by losing money through the lending in the mortgages, the loses it was making and filing for bankruptcy which increased panic in the financial and investment industry. The bankruptcy also caused depreciation in commercial real estate prices.

Oil Effect on the Global Financial Crises

The effect of oil prices to the global financial crisis was a big one. The subprime bubble which is seen as the greatest contributor to the global financial crisis, is attributable to oil price fluctuations, making oil the probable major cause, greater than even the subprime mortgages. The price of oil rose from less than thirty dollars per barrel in 2003, to over 130 dollars per barrel i n 2008. This had a very great effect on everyone’s finances, the country’s as well as the global economy.

The high prices of oil increased the oil revenues for oil exporters, worsening the current account of oil importers from the oil import costs. This greatly affected the credit crunch of 2008. The increase in oil prices indirectly caused the federal fund rate from one in 2005 to 5.25 in 2007, increasing the annual household mortgage repayments by about 33%.

The above increase mortgage rate coupled with an average household doubling of gasoline expenditure, the total increased expense per family increased considerably. This increase in costs, among others made it difficult for households to afford payments for the mortgage installments leading to the defaults.

From above, it is clear that oil prices contributed in busting of the subprime mortgages which caused the credit crunch and the whole global financial crisis.

Effects of the Financial Crisis

The global financial crisis affected many spheres of the economy. One area affected was the GDP. The production of goods and services reduced drastically after the crisis. This reduced the growth of the economies considerable. There were job cuts as many companies could not afford to stay in business with high salary expenses, yet the sales were also going down due to lack of purchasing power of most citizens. The cost of production was also high following an increase in fuel prices and banks interests rates increased, as well. All these factors slowed down the growth of most economies.

The crisis made cost of credit very high and the vetting procedure more strict, denying many qualifying applicants the chance to access loans to fund business or acquire mortgages. The banks are also increasing rates as a cautionary measure, and partly also to ensure they recoup some of the money lost at the subprime mortgages, whose payment was never honoured.

Governments such as the US spent a lot of money to bail out the affected companies to prevent them from collapsing. Such monies would have been used in other economic activities.

Some countries were so badly hit that they became bankrupt. Iceland for instance became bankrupt and could not afford imports. Brazil currency, the krona lost more than 50% of its vale while others like Pakistan had their poverty levels rise and more people unable to afford a meal, increasing malnutrition in the country.

Liquidity problem is being experienced in many countries after the financial crises. Countries are struggling with inflations and recession. The situation is improving, but full recovery is not yet experienced.

Price of various commodities in the global market is reducing due to low demand as many people try to cut costs. For instance, mining in South Africa has reduced and some companies laying off workers and others downsizing. The cost of gold and diamonds s from the countries who mine has also reduced drastically. This is because of the reduced demand as more people are not buying jewelry quite often given the current economic conditions.

The federal ban and other central banks of the world have taken measures to ensure that such a problem does not happen again. These measures are to ensure that the effect is not very disastrous to the economy if it ever happens again. This is by stimulus programs that will jumpstart the economy and have it sustainable even in turbulent financial times.