HOUSING BUBBLE AND THE FINANCIAL CRISIS

Question No – 29

Introduction:

Housing bubble or property bubble

Housing bubble or property bubble results in the rapid growth of real estate prices and mortgage credit. When demand for real estate increases significantly, it exceeds the supply. Supply becomes tight in the short term because it takes some time to build a new house. With exceeding demand, prices and rents climb up. The growth of both price and demand supports outstanding loans, and mortgage credit accelerates. Speculators enter the market, believing that profits can be made through short-term buying and selling. Then they drive demand up even more. At some point, demand stops growing and the supply increases, resulting in a sharp drop in prices — and the bubble bursts.

Financial crisis

Financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults. Financial crises directly result in a loss of paper wealth they do not directly result in changes in the real economy unless a recession or depression follows.

Discussion:

Following the burst of the ‘dotcom’ bubble in 2000 and the 2001 terror attacks on the United States, the US and most other advanced economies embarked on a period of Sustained expansionary economic policies to ward off recession. The Federal Reserve, For instance, lowered its discount rate no less than 27 times between 2001 and 2003 Low interest rates, facilitated by the huge trade surpluses which China and other Countries used to purchase US Treasury Bonds, stimulated rapid growth in credit. Accompanying rises in house prices further fuelled credit growth, especially through Mortgage lending. In the US, sub-prime market mortgage lending, to households without the essential means to repay loans, took on huge proportions.

By the summer of 2007 increasing defaults on mortgages and growing numbers of Foreclosures in the US signaled that the sub-prime market was in crisis. House prices And financial stock prices started to plummet.

In the wake of the crisis in the US, the biggest initial fear in the rest of the world was That of financial contagion. This is the danger that financial institutions in developing Countries will be negatively affected. There are both direct and indirect ways in which this can happen. Directly, banks in developing countries may be affected to the extent to which they hold Assets contaminated by sub-prime mortgages. Many developing-country banks had limited interrelationships with foreign owned banks. There is, however, a more serious indirect threat through declines in stock market prices and housing prices. These reduce the capital of banks (and of other big firms), which in particular causes problems where they do not hold sufficient levels of their capital in cash. In such cases it is likely that banks will reduce lending in order to shore up their capital. In a worst-case scenario banks may face solvency problems and may require their governments to recapitalize them. Reductions in bank lending will have the impact of reduced investment, lower growth, and an increase in unemployment.

Even if most developing countries are spared significant damage to their own financial Systems, the fact that the advanced economies are entering a recession is likely to hurt them. For now though, it should be noted that the potential may be Significant, given that most developing countries have been basing their economic Growth in recent years on exports. Declines in commodity prices will be detrimental to the export earnings of a large Number of countries that are major exporters of commodities. But it is not just commodity-dependent countries that will be adversely affected. Recession in the United States and other G7 countries will in general reduce the demand for their exports, as these markets are important destinations of developing-country Exports. A significant proportion of US imports are from developing countries. Many of These imports are also imports of services, not just goods.

Possible outcomes:

A valid global concern is that the possible combination of banking failures and Reductions in domestic lending, reductions in export earnings, and reductions in financial flows to developing countries will end up reducing private sector investments, household consumption.

This in turn will lead to reduced government expenditure, as governments will now face the higher cost of raising funds coupled with less tax Income. Together, low investment, consumption and government expenditure could spell higher unemployment and poverty across the developing world.

Conclusion

Having studied financial crises, I come to the conclusion that crisis is ultimately political in nature. Even if it erupts as a financial crisis, its resolution would inevitably be political because the distribution of losses would be highly arbitrary and controversial. Ultimately, all financial crises are crisis of governance. Financial crises prove that financial engineering cannot create perpetual prosperity. It takes good governance, at the corporate, financial and social level, to generate long-run sustainable stability. All crises have to be solved by governments, and if not satisfactorily, by the next government. The bursting of the US housing bubble could have serious adverse consequences for the United States. Although the size and speed of the bursting of the bubble is unknown, on the scale of shock simulated here the bursting of the bubble could be sufficient to put the United States into recession a year later.

References:

· Google.com

· wikipedia.in

Submitted to – Mr Gurdeepak Singh

Submitted by – Ishtdeep Singh

Class – Mba (Semester 1)

Section – A