The severe decline in the state of world economy in the last two years is a culmination of several factors. But the bursting of the housing bubble in the United States alongside a precarious credit crunch situation have played major roles in precipitating the latest episode of economic recession in many countries. While the advanced nations in North America and Western Europe have borne the brunt of the recession, lesser developed economies and several emerging markets are simultaneously experiencing a slowdown in economic activity. Financial analysts and political commentators point out that the unregulated financial markets of Western democracies make such crises inevitable. The proponents of free market capitalism, on the other hand, do not concede this point. This essay will foray into the conditions that led to the present crisis in the housing market and try to assess the merits of remedial policy measures in this regard. The evaluation of the stimulus and bailout packages is followed by an inquiry into policy directions for the coming years. It will also place the prospects of the housing market in the broader context of revival of the economy both in the United States and abroad.
The Federal Reserve, which has the power to decide the course of the economy, has been criticized for its lack of foresight. Although the actions of the Federal Reserve in the initial years of the Bush Administration are to be credited for the housing boom, exercising fiscal prudence could have mitigated the present crisis. According to John Gnuschke,
“Daily evidence of the continuing erosion of the housing market, the associated disruption of financial and credit markets, and the spill-over impacts to other segments of the real estate industry are taking their toll on the broader economy. While the real estate industry continues to be a major component of the economy, the dramatic and overly-aggressive increases in interest rates promoted by the Federal Reserve Bank (between 2001 and 2007) have caused a major disruption in national and international markets”. (Gnuschke, 2007, p.4)
Another reason for the decline of the housing market is the unmitigated expanse of mortgage lending across income groups. In spite of being warned by the former chief of Federal Reserve, Alan Greenspan, the financiers continued to ignore unpleasant realities. The transition of Chairmanship from Alan Greenspan to Ben Bernanke has so far not brought a change in the policy direction. When the markets are booming and there is plenty of credit available due to reduced interest rates, it is tempting to ignore warning of impending doom. This is precisely what precipitated the collapse of the housing market in particular and the economy in general. For example, lenders such as HSBC, who own the American company Household International, thought of mortgage lending as a lucrative opportunity to make profits. Such willing lenders catered to low-income individuals, who were keen to take advantage of the apparent rise in house values. At the same time, new financial market instruments such as ‘sub-prime mortgages’ were introduced. In other words, “the mortgage debts, offering better-than-usual returns (because of the low quality of the borrowers) would be packaged up into neat parcels–known technically as “collateralized mortgage/loan obligations”–and parked with banks and investment funds around the world” (Alex Brummer, 2007, p.17). It is easy for unsuspecting low income investors to succumb to the lure of these complex derivative products. But in reality, their real value is significantly lower than what is quoted in the financial markets, the latter being the result of speculation.
But the high risk contained in these sub-prime mortgages was not nominal but very real. This precarious balance was sustainable only as long as the housing prices remain affordable and interest rates remained low. And it did not take long for Greenspan’s fears to turn to reality.
“No sooner had Greenspan spoken than the housing bubble burst. Prices across the United States plunged. House builders were left with unsold stocks and the sub-prime mortgage lenders found not only that they had lent funds to people who had no realistic prospect of paying back, but the securities against which they had lent were worthless. HSBC alone lost [pounds sterling] 5bn.” (Brummer, 2007, p.17)
Financial experts also failed to take into account the likelihood of inflation. This misplaced optimism was to prove a disaster. For example, the belief that inflation is a thing of the past encouraged financial institutions to borrow money long-term at very low interest rates. But when energy prices remained high for a protracted period and demand for commodities from emerging economies increased substantially, it made borrowing money close to impossible. In this scenario, the bond markets started to reverse direction, and longer-term borrowing turned more expensive once again. The financial institutions that had borrowed cheaply did not expect the sudden rise in the cost of transactions. But, most of these financial institutions, including such names as Goldman Sachs, Bear, Stearns & Co., Barclays Capital, etc manage to evade negative consequences, as they had “repackaged debts of all kinds, including sub-prime mortgages, into derivative products known collectively as asset-backed securities” and passed it on to market participants. Speculative rallies further inflated the price of these securities (Roubini, 2008, p.45).