By Max Ganik
May 8, 2012
In 2008, the economy endured one of its most catastrophic crashes since 1929 due to the housing bubble burst. This destructive housing bubble burst wiped out people’s investments and ruined many people’s lives. Many Americans went from expecting a prosperous future to fearing the disastrous outcome from the economic downfall. The bursting of housing bubble also impacted many financial institutions. The steps taken to correct the crash had minimal impact. The causes of the housing bubble were faulty mortgage lending practices and a lack of personal and governmental responsibility.
A housing bubble is an artificial increase in housing prices caused by increased demand and speculation (Investopedia.com). The main factors leading to the housing bubble were the private and government mortgage practices that enabled unqualified buyers to purchase their homes. These mortgages permitted people to purchase homes that they couldn’t afford. The process of giving mortgages to such unqualified recipients was implemented by the concept termed “subprime loans” (Goldfarb 3). According to Roger Altman, “U.S. subprime loans rose from a long-term average of approximately $100 billion to over $600 billion in 2005 and 2006” (Altman 2). Many banks offered subprime loans to boost their profits.
The biggest subprime mortgage providers were Freddie Mac and Fannie Mae. These two companies participated in such mortgage practices so that they would be able to report substantial profits to their shareholders (Goldfarb 3). According to Zachary Goldfarb, “Freddie Mac and Fannie Mae, otherwise known as “kings of leverage”, borrowed $75 for every dollar they had reserved as a financial cushion” (Goldfarb 3). This is termed as 75:1 leveraging. Leveraging on an investment is a way to multiply profits and losses by a multiplier effect that is in this case by 75 times. The bigger the leverage is, the greater the investment risk or reward. In this crisis, Freddie Mac and Fannie Mae had multiplied their losses by 75 times because their leverage was 75:1 (Goldfarb 3). The use of leverage is very risky and could easily deliver significant losses and in this case wipe out an entire corporation.
Another major contributor to the housing bubble was the Federal Reserve. This is the central banking system that handles almost all of the financial decisions of the United States. The Federal Reserve kept interest rates low in order to entice potential buyers into buying homes (Altman 2). Low interest rates gave many potential homeowners the false sense of security that they could manage the responsibility of their loans. With this homeowner confidence, more people purchased homes. This, in turn, led to the increase in housing prices. According to Roger Altman, “The flood of mortgage money caused residential and commercial real estate prices to rise at unprecedented rates” (Altman 2). The Federal Reserve believed that low rates would spice up the housing market and give the necessary incentive to the consumer to purchase homes.
More and more buyers and investors were able to purchase real estate. As a result, real estate became a commodity. Once something becomes a commodity is has the possibility to significantly rise or fall depending on the situation. In this case, the value of real estate significantly decreased. The housing bubble burst at this point.
As a result of the burst, with the decreased value of real estate, many of the unqualified loan recipients needed to go through a foreclosure (Goldfarb 2). This is a process where the bank seizes homes of homeowners that cannot afford their loan repayments. The banks were attempting to save their investment with the remaining foreclosed value of the home. Why did the housing bubble burst and why were so many going through foreclosures?
Everyone was trying to decipher the causes and the impact of this economic tragedy in order to identify what steps should be taken to regenerate the economy. As the issues were analyzed, it became clear that the banks and many individuals had been investing in real estate at the exorbitant housing prices, at the height of the bubble period (Thomas 1). We learned that the strategy of giving unqualified buyers loans backfired on the banks and the two main government mortgage providers (Freddie Mac and Fannie Mae), as huge losses jumpstarted the housing market crash (Altman 4). People feared for their financial stability, but in the first place why were they taking loans that they couldn’t afford?
When the banks were giving out mortgages, not only should the banks accept responsibility of the mortgages, but so should the individuals. When an individual takes out a mortgage, it is important that the person knows all the details of the mortgage obligation and understands the expenses and repayment requirements of the loan (Altman 2). In 2008, people were accepting loans without the financial means to pay back. Once the housing bubble burst, people didn’t have the funds to pay back their loans because their property’s value fell drastically. The amount they owed was more than the value of the property, which is why they had to go through the foreclosure process.
Moreover, the housing market collapse caused a domino effect on other aspects of the economy, the entire stock market. When the stock market crashed in 2008 due to the bubble burst, it caused many other sectors and businesses to fall as well (Lindsey 4). As people had less money to shop, the stores lost revenue and began to have major problems. To prevent fear running rampant, the government decided to intervene to try to bring some of the confidence back to the individual investor.
The government took a major step to reduce the impact of the crash with the Troubled Asset Relief Program (TARP), signed by President Bush on October 3, 2008. The TARP is also known as Quantitative Easing (QE1). Quantitative easing is the process of printing money in order to jumpstart (rehabilitate) the economy (Barlett and Stelle 2). In this case, the money was given to the banks that needed assistance in regaining their capital (Barlett and Steele 8). Quantitative Easing was put into place to regenerate the economy.
Some experts indicated different reasons why the economy crash occurred, and that the mortgage practices weren’t the primary reason. They instead focused on the internal processes of the stock market as the culprit of the crash, in particular the process of High Frequency trading (Patterson and Rogow 1). This trading process is the execution of computerized trading algorithms that is used for extremely short position-holding periods; this can range from a few seconds to a few minutes. The computerized trading creates market volatility that leads to the market having sharp moves, either positive or negative. These experts feel that the exacerbated volatility crash. Another reason that the stock market crashed, they felt, was because of the excessive buying in the stock market. When stock prices skyrocket, it can lead to a huge decline, because what goes up must go down. (Paterson and Rogow 2). These experts believe that the stock market was the reason why the economy collapsed, which in turn brought down the housing market.
Even though these stock market issues occurred in tandem to the housing bubble, the consensus view is still that the main reason for the economy crash was the burst of the housing bubble. None of the other reasons on why the economy crashed compare to the effects of the housing bubble on the market, and the lasting impact that it continues to have on the United States economy.
We now understand how the housing bubble was formed from inappropriate mortgage lending procedures and lack of financial responsibility by the individual and by the government practices. Once the housing bubble burst, it affected multiple aspects and sectors of the economy. The government was forced to intervene in order to protect the banks, and in turn, the country, from a bigger catastrophe than already existed (Altman 2). The housing market and the economy are slowly climbing back, but there are still many issues and questions around the appropriate strategies to move forward more effectively, to bring confidence back, and to enable the economy to grow.
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