Essay: Decline in Housing Prices and Economic Consequences Housing Bubble

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Decline in Housing Prices and Economic Consequences of the Housing Bubble

The Origin and Factors Responsible:

The origin of the crisis can be ascribed to 4 features. (i) the first and foremost relates to the immense growth in the financial products as well as financial practices that included high levels of leverages which were being sustainable only under situations of rising confidence of the investor and asset prices. In the U.S., sub-prime mortgage lending is the apparent illustration that started the crisis, however the issue was considered to be more pervasive because of the second factor relating to 'liquidity creation' which was uncontrolled. (ii) it is important to note that modern financial engineering has driven liquidity growth mechanisms focused on 'collateralized lending' like 'securities lending', 'repos' as well as 'margin lending', in which the 'active security market' with regard to the collateral implied that lenders had not themselves perceived being exposed to considerable 'liquidity' or that of 'counterparty risk'. Even though 'asset price inflation' was at high levels, the Apex Bank concentrated on 'real sector activity' and 'consumer price inflation targets' and they did not react by trying to contain liquidity and 'pricking of the bubble'. (iii) the third factor as the rise of the mostly "shadow banking" arena which was unregulated, wherein there was an overwhelming participation of "conduits, hedge banks, SIVs, investment banks," and so on as also the formulation of intricate financial techniques and mechanisms that witnessed the risk to spread across the international financial arena and considerable 'interdependencies' built. (iv) There was a lack of public information regarding the distribution and the level of risk involved in the 'financial system'. Lack of suitable mechanism to evaluate the levels of risk of probable counterparties implied that a crisis which tempted reaction for several institutions was just to stop lending additional credit. (Davis, 1) an eye-opener has been the linking the beginning of the crisis relating to sub-prime to the 'introduction of the ABX' indices during the year 2006 that gave the initial aggregate, estimates that were market-based relating to 'subprime linked securities value'. (Davis, 1) Although the concerns regarding housing rates in the U.S. And 'sub prime mortgage defaults' were also surfacing, the indices helped participants in the market to articulate, and trade on, opinions regarding the effects for the CDOs, wherein the values had been eventually associated with the U.S. housing rates through complex relations which included 'securitizations of sub-prime mortgages' which were complex in nature. (Davis, 1)

The Decline in Housing Prices and its Economic Outcomes:

The international financial system has been facing one of the most intricate and serious credit crunches in history. The events have followed in increased succession from the 'subprime mortgage market' collapse in the U.S. which started from last summer. Starting from the all-time record first half year in the year 2007, financial institutions nosedived in few weeks time. Early hopes regarding subprime crisis that it would be checked and not overflow to other areas of the international financial system were to be masked as it had become more and more evident that the sub-prime mayhem was not the actual reason for the crisis. It was merely the trigger issue for the fallout of an unparalleled credit bubble of upsetting dimensions. Further aggressive levels of 'monetary easing' as well as a sustained phase of low levels of interest rates in concert with massive 'product innovation' with regard to 'structured credit markets' was the vehicle for an extraordinary growth in the area of credit lending as well as in leverage. This surplus lending and more than adequate leverage as an indication of intense risk taking by the credit investors happened against a backdrop of a very benevolent macroeconomic atmosphere typified by the best of all the worlds, robust global development as well as low levels of inflation. (Felsenheimer; Gisdakis, 9)

As a result of the 'U.S. housing bubble' burst, the housing market in the U.S. is presently witnessing the most acute recession. Ever since the Great Depression in 1929, matters have obviously changed. However it is not considered to be the massive recession in the U.S. housing market that is the cause for problems. On the other hand, it is the growing systemic risk in the international financial system as a result of the avalanche in 'structured credit markets' that might possibly result in a credit crunch having severe effects for the real economy which makes central bankers, policy makers as well as regulators on increased levels of alert. As per the lending surveys of central bank, banks throughout the world have since then started to be overcautious extensively in their lending standards. Moreover growing risk provisions and reducing quality of asset as also added 'write-down' require credit products which are structured to follow to reduce the capital adequacy levels of the banks. As a result, several financial institutions have been pressurized to reduce risk against assets, obtain new equity capital as well as reduce their activity relating to lending. Apart from that, the absence of transparency pertaining to the potential amount of the losses as well as the distribution pertaining to those losses avoids a speedy recovery of the confidence relating to financial markets. (Felsenheimer; Gisdakis, 9)

One of the most significant consequences relating to the subprime crisis reveals the manner whereby the potential of a central bank in order to bail the market in the midst of a credit crisis is restricted. However it does not imply that the efforts of Fed have not been necessary, but that it could only combat the symptoms. One of the signs was the faulty money markets. Some days after the crisis had begun, 'money market spreads' began to broaden in a dramatic fashion. The inter-bank market was not working in a proper manner. The striking enhancement in 'money market spreads' took place since banks were unwilling in the 'inter-bank market' to 'lend cash'. This was not so much propelled by the alarm that the counterparty could default over the following 3 months, however because banks accumulated all of the cash they could get so as to finance their functioning business. (Felsenheimer; Gisdakis, 27)

Judging from this angle, the spread of 'money market' is a 'liquidity premium' and not so much of the 'credit spread'. Because the 'credit crisis' caused a total showdown of 'bond markets' and 'structured finance', banks had difficulties in getting funding for their lending business. As per certain illustrations revealed, banks might actually issue bonds, however at very 'high spreads'. But tapping the market by means of a 5-year bond as well as paying 70bp shows that the banks has issues of "pain" with regard to '70 bp premium' over the coming 5 years. However banks were anticipating that 'primary markets' might tend to reopen over the next few months. Therefore, they were accepting increased 'money market spreads that they would only have to pay for a few months' in the hope that funding might be more attractive in times to come. (Felsenheimer; Gisdakis, 28)

Effect on Banks, FIs and Pension Funds:

The sub-prime crisis is identical for what is a significant watershed in our economy as well as our culture. It is, at its base, the outcome of a speculative bubble in the housing market which started to burst in the year 2006 in U.S. And has now resulted in ruptures in lot of other nations as financial failures and an international credit crunch. The force which has been unleashed by the 'sub-prime crisis' would possibly run unbridled for several years, threatening increasing 'collateral damage'. The commotion in the credit market is already of remarkable levels and will have significant economic outcomes. More significantly, this crisis has paved the way for basic changes in society and the changes that impact our values, consumer habits, and our relatedness towards one another. (Shiller, 1) While the effects relating to the sub-prime crisis are universal, the crisis itself has to be perceived in its place as well as the period of its origin i.e. The U.S. In the 20th century. The present financial crunch is often considered as a cause to sound retreat- to move back to simple mechanisms relating to the financial dealings of yester years. This would be considered a mistake. On the other side, the present circumstance is of course an opportunity to expand our activities in order to rethink and enhance our institutions relating to risk management, the framework which undergirds our more and more financials sector which is sophisticated. (Shiller, 3-5)

Modern finance has spawned historic heights during the past few decades and is a strong vehicle relating to economic growth, from that of underwriting new levels of businesses pertaining to the private sector to support important research in the universities to build hospitals and schools in the public sector. Each crisis has the elements of change. It is now the period to 'restructure the institutional firmament' relating to the financial activity in positive methods that would make the economy stable, "rekindle the wealth of nations,… [END OF PREVIEW]

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