Guide Housing Boom and Bust: Owner Occupation, Government Regulation and the Credit Crunch

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While elements of the crisis first became more visible during , several major financial institutions collapsed in September , with significant disruption in the flow of credit to businesses and consumers and the onset of a severe global recession.

Lest We Forget: Why We Had A Financial Crisis

There were many causes of the crisis, with commentators assigning different levels of blame to financial institutions, regulators, credit agencies, government housing policies, and consumers, among others. Investors, even those with prime credit ratings, were much more likely to default than non-investors when prices fell. When U. As adjustable-rate mortgages began to reset at higher interest rates causing higher monthly payments , mortgage delinquencies soared. Securities backed with mortgages, including subprime mortgages, widely held by financial firms globally, lost most of their value.

Global investors also drastically reduced purchases of mortgage-backed debt and other securities as part of a decline in the capacity and willingness of the private financial system to support lending. The crisis had severe, long-lasting consequences for the U. The U. The number of jobs did not return to the December pre-crisis peak until May The immediate cause of the crisis was the bursting of the United States housing bubble which peaked in approximately — However, once interest rates began to rise and housing prices started to drop moderately in — in many parts of the U.

Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices fell, and adjustable-rate mortgage ARM interest rates reset higher. As housing prices fell, global investor demand for mortgage-related securities evaporated. This became apparent by July , when investment bank Bear Stearns announced that two of its hedge funds had imploded. These funds had invested in securities that derived their value from mortgages. When the value of these securities dropped, investors demanded that these hedge funds provide additional collateral.

This created a cascade of selling in these securities, which lowered their value further. Economist Mark Zandi wrote that this event was "arguably the proximate catalyst" for the financial market disruption that followed. Several other factors set the stage for the rise and fall of housing prices, and related securities widely held by financial firms.

In the years leading up to the crisis, the U. This inflow of funds combined with low U. Loans of various types e. As part of the housing and credit booms, the number of financial agreements called mortgage-backed securities MBS , which derive their value from mortgage payments and housing prices, greatly increased.

Such financial innovation enabled institutions and investors around the world to invest in the U. As housing prices declined, major global financial institutions that had borrowed and invested heavily in MBS reported significant losses. Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy.

Global Financial Meltdown - One Of The Best Financial Crisis Documentary Films

Total losses were estimated in the trillions of U. While the housing and credit bubbles were growing, a series of factors caused the financial system to become increasingly fragile. Policymakers did not recognize the increasingly important role played by financial institutions such as investment banks and hedge funds , also known as the shadow banking system.

These entities were not subject to the same regulations as depository banking.

Further, shadow banks were able to mask the extent of their risk taking from investors and regulators through the use of complex, off-balance sheet derivatives and securitizations. The complexity of these off-balance sheet arrangements and the securities held, as well as the interconnection between larger financial institutions, made it virtually impossible to re-organize them via bankruptcy, which contributed to the need for government bailouts.

The losses experienced by financial institutions on their mortgage-related securities impacted their ability to lend, slowing economic activity. Interbank lending dried-up initially and then loans to non-financial firms were affected.

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Concerns regarding the stability of key financial institutions drove central banks to take action to provide funds to encourage lending and to restore faith in the commercial paper markets, which are integral to funding business operations. Governments also bailed out key financial institutions, assuming significant additional financial commitments. The risks to the broader economy created by the housing market downturn and subsequent financial market crisis were primary factors in several decisions by central banks around the world to cut interest rates and governments to implement economic stimulus packages.

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Effects on global stock markets due to the crisis were dramatic. Between 1 January and 11 October , owners of stocks in U. Losses in the stock markets and housing value declines place further downward pressure on consumer spending, a key economic engine. The crisis can be attributed to several factors, which emerged over a number of years. Causes proposed include the inability of homeowners to make their mortgage payments due primarily to adjustable-rate mortgages resetting, borrowers overextending, predatory lending , and speculation , overbuilding during the boom period, risky mortgage products, increased power of mortgage originators, high personal and corporate debt levels, financial products that distributed and perhaps concealed the risk of mortgage default, monetary and housing policies that encouraged risk-taking and more debt, international trade imbalances , and inappropriate government regulation.

Among the important catalysts of the subprime crisis were the influx of money from the private sector, the banks entering into the mortgage bond market, government policies aimed at expanding homeownership, speculation by many home buyers, and the predatory lending practices of the mortgage lenders, specifically the adjustable-rate mortgage, 2—28 loan , that mortgage lenders sold directly or indirectly via mortgage brokers. In its "Declaration of the Summit on Financial Markets and the World Economy," dated 15 November , leaders of the Group of 20 cited the following causes:.

During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system.

Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions. He wrote that there were shocks or triggers i. Examples of triggers included: losses on subprime mortgage securities that began in and a run on the shadow banking system that began in mid, which adversely affected the functioning of money markets.

Examples of vulnerabilities in the private sector included: financial institution dependence on unstable sources of short-term funding such as repurchase agreements or Repos; deficiencies in corporate risk management; excessive use of leverage borrowing to invest ; and inappropriate usage of derivatives as a tool for taking excessive risks. Examples of vulnerabilities in the public sector included: statutory gaps and conflicts between regulators; ineffective use of regulatory authority; and ineffective crisis management capabilities.

Owner Occupation, Government Regulation and the Credit Crunch, 1st Edition

Bernanke also discussed " Too big to fail " institutions, monetary policy, and trade deficits. During May , Warren Buffett and Paul Volcker separately described questionable assumptions or judgments underlying the U. These assumptions included: 1 Housing prices would not fall dramatically; [45] 2 Free and open financial markets supported by sophisticated financial engineering would most effectively support market efficiency and stability, directing funds to the most profitable and productive uses; 3 Concepts embedded in mathematics and physics could be directly adapted to markets, in the form of various financial models used to evaluate credit risk; 4 Economic imbalances, such as large trade deficits and low savings rates indicative of over-consumption, were sustainable; and 5 Stronger regulation of the shadow banking system and derivatives markets was not needed.

Financial Crisis Inquiry Commission reported its findings in January It concluded that "the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserve's failure to stem the tide of toxic mortgages; Dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk; An explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; Key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels.

There are several "narratives" attempting to place the causes of the crisis into context, with overlapping elements. Five such narratives include:.

Underlying narratives is a hypothesis that growing income inequality and wage stagnation encouraged families to increase their household debt to maintain their desired living standard, fueling the bubble. Further, this greater share of income flowing to the top increased the political power of business interests, who used that power to deregulate or limit regulation of the shadow banking system.

According to Robert J. Shiller and other economists, housing price increases beyond the general inflation rate are not sustainable in the long term. From the end of World War II to the beginning of the housing bubble in , housing prices in the US remained relatively stable. It was fueled by low interest rates and large inflows of foreign funds that created easy credit conditions.

In it rose to 4. While housing prices were increasing, consumers were saving less [62] and both borrowing and spending more. By , this figure had increased to This credit and house price explosion led to a building boom and eventually to a surplus of unsold homes, which caused U. These mortgages enticed borrowers with a below market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage's term. Borrowers who would not be able to make the higher payments once the initial grace period ended, were planning to refinance their mortgages after a year or two of appreciation.

Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default.

Government policies and the subprime mortgage crisis - Wikipedia

As more borrowers stopped making their mortgage payments, foreclosures and the supply of homes for sale increased. This placed downward pressure on housing prices, which further lowered homeowners' equity. The decline in mortgage payments also reduced the value of mortgage-backed securities , which eroded the net worth and financial health of banks.

This vicious cycle was at the heart of the crisis. By September , average U. As of March , an estimated 8. Borrowers in this situation have an incentive to default on their mortgages as a mortgage is typically nonrecourse debt secured against the property. He concluded that the extent of equity in the home was the key factor in foreclosure, rather than the type of loan, credit worthiness of the borrower, or ability to pay.

Increasing foreclosure rates increases the inventory of houses offered for sale. The number of new homes sold in was By January , the inventory of unsold new homes was 9. This overhang of unsold homes lowered house prices. As prices declined, more homeowners were at risk of default or foreclosure.

House prices are expected to continue declining until this inventory of unsold homes an instance of excess supply declines to normal levels.