Subprime Mortgage Crisis

Subprime Mortgage Crisis

Introduction

In this essay I will try to explain the causes of the mortgage crisis. I will explain the mechanism behind the credit crisis.

The mortgage crisis is a typical example of a macroeconomic issue, indeed the financial system is one of the factors studied in macroeconomics. A non-exhaustive list of factors could be national income, savings, production, consumer inflation, unemployment, investment, international trade, interest rate and international finance. Obviously subprimes are a concern to international finance, along with interest rates as I will explain later. The consequence of the meltdown was worldwide. Indeed different banks in the U.S and Europe needed to be bailed out because they were betting on the U.S mortgage market. The crisis started in the U.S but spread rapidly around the world in a few weeks with different impacts in different countries. Governments from all around the world tried to save the system by bailing out enormous amounts of money. In order to avoid a complete crash of the financial system, governments had to enter into the capital of some of the most important banks that, without help were ready to go bankrupt. These decisions were completely macroeconomic. Governments from the U.S and Europe has to react quickly to, firstly the lack of liquidity generated by the enormous loss, and secondly the lack of confidence. In this essay I will focus on the causes of the growth of the subprime bubble.

Motivation

The subprime crisis was the first major crisis that I was capable of understanding seriously. The long term effects, propagated through chain reactions, seemed to me to be completely disproportionate. Indeed, a local crisis based on local assets such as houses in a few months has affected the financial system of the entire world. A second crisis called credit crunch has even followed the subprime crisis. I wanted to understand the complex interweaving of different phenomena. Indeed different actors can be seen; the Government, banks and hedge funds, and insurance company seemed to be the most important. Those kinds of phenomena are absolutely impossible to apprehend properly without a deep knowledge in macroeconomic but by reading different reports I was surprised how I was able to understand this major crisis.

This work seemed to be an excellent opportunity to deepen my knowledge in this matter.

The Housing Bubble the FED explanation

Economists agreed that a bubble has to have a growth rate bigger that the interest rate. Indeed the growth of a bubble has to be relatively faster than the interest rate to be attractive to the investor. (Ventura).

Just after the dot.com bubble in order to restore an economic growth Alan Greenspan and his colleague from the FED decide to lower the interest rate from 6.4 to 1% (Bianco, 2008).

When the interest rates a low it will push the economy to expand. The economy will expand because the price of lending money is very low. Businesses fell free to borrow money and they will have to spend only a small amount of money to reimburse the debt. The Fed use this tool very often. The interest rate has already work in the past and show that it could be a very powerful tool of the economy. After the dot.com bubble the fed by fear to go into recession, The FED decide to lower the rate despite the fact that it wasn't a good reflexion of the real economic activity.

The president of the Federal Reserve of Dallas said that "the "FED's interest rate policy during the period of 2000-2003 misguided by erroneously low inflation data lead to the housing bubble".

The FED has ignored the relationship between the TED Spread (the difference between the interest rate at which the US Government is able to borrow on a three month period (T-bill) and the rate at which banks lend to each other money on a three month period (measured by the Libor (Lexicon, Financial Times) and the growth of the housing price in U.S. Indeed the TED was so low that that inventors saw in the housing market a good alternative. Indeed it was a great opportunity to raise liquidity. The growing price of the house market makes the model even more secure.

The exhibit 1 shows how the U.S treasury went to almost 6.5 % to less than 1% in January 2004.

During the period 2004 to 2006 the FED start to increase the U.S Treasury bond, in just two

Years the FED increase 17 times the interest rate from the low 1% to 5,25% (Bianco, 2008). It was a great effort but too late the housing market has already takes the form of a bubble. The Fed stoped to raise the interest rate, by fear that the downturn of the housing market will have dramatic consequences in the world economy. In fact it was to late. Roubini from the New York University explain that the FED should have tightened up the interest rate very long time before and not let the housing bubble appear. Indeed the market for loanable found grew during the period 2004-2006 $386 billion in 2000 to $2.2 trillion in 2007 (James R. Barth). Freddie Mac CEO Richard Syron, said that the housing market was over evaluated and a correction counted for trillion of dollars will occur. (Bianco, The Subprime Lending Crisis: Causes and Effect of the Mortgage Meltdown, 2008) Alan Greenspan the president of the FED add that a "large double digit declines" has to be expected in the US housing market. (Bianco, The Subprime Lending Crisis: Causes and Effect of the Mortgage Meltdown, 2008)

Mechanism behind the Lending of mortgage

As explained above, banks and investors during the period 2004-2006 were looking for lucrative opportunity because of the very low rate of the U.S treasury. They found in the housing market a great opportunity. The price of houses didn't go down during the last twenty years ^ (Case Shiller Housing Price Index-Dec 08) even better from 1997 to 2004 the average price of a house increase by 124%. (The Economist, 2007) Because the house is the security of the loan the fact that the price never went down make the loan very secure and thus extremely attractive for the borrower. Bank use the history cost as a good model for the future price of the houses. The historic price model has been proved first and to be completely wrong.

Lender believing that the price of the house will continue to grow downs their criteria for accession to a loan at a ridiculously low level. The fact that the price of the house will increase secures the loan perfectly. In consequences