Best Article on Subprime Mortgage Crisis

Why is the US Economy Facing A Recession?

Readers Question: Why is the US economy facing an economic meltdown?

The US economy faces many severe problems, a falling stock market, record levels of public debt, banks on the verge of bankruptcy, frozen money markets, a plummeting dollar and the imminent threat of a recession. How did the US economy get into such a desperate situation?

The Housing market

The housing market plays a crucial role in determining consumer spending and therefore the rate of economic growth. When house prices are rising, consumers experience an increase in wealth; this boosts their confidence and enables them to remortgage and gain equity withdrawal to spend. When house prices fall, the opposite happens.

The Housing Bubble.

Up until 2006, US house prices rose rapidly; against a backdrop of rising house prices many analysts felt that even risky mortgage loans were safe and this encouraged even more unsuitable mortgages. For example, it was hoped 100% mortgages would be easier to pay back because rising prices would give homeowners an effective deposit.

The combination of low interest rates, aggressive marketing of mortgages and overly optimistic predictions for the housing market caused house prices to rise. However, the ratio of house prices to income went far above the long run trend rate; making mortgages increasingly unaffordable for first time buyers. Then in 2006 the Fed were forced to raise interest rates to over 4% because of inflationary pressure in the economy. This increase in interest rates caused many mortgage owners to struggle with their repayments. Also, there was another problem – many new mortgages were ‘balloon mortgages’ this means that for the first two years homeowners had a specially low introductory rate. However, after two years, the mortgage rate suddenly shot up increasing monthly payments very significantly. Therefore, first time buyers who had stretched themselves to get a mortgage suddenly found themselves with a large increase in monthly payments. There are several examples of homeowners with mortgage payments greater than their total income. These mortgages should never have been sold, but, in the housing boom there was a lack of self regulation. The needs of the consumers were ignored in the pursuit for selling ‘profitable mortgages’

The Housing Bubble Bursts

Therefore, with a rise in defaults and fall in affordability, the US housing market turned. Suddenly after years of growth, the ‘unthinkable’ happened and house prices started to fall. This came as a shock to many who assumed house prices could only rise. Therefore, people who had been speculating in the housing market felt this was the time to get out and sell. Therefore, prices fell even more. Since their peak in 2006, house prices have fallen by 10% (in some areas it is much higher, the housing market is very localised). Furthermore, there is still the prospect of even more falls in house prices. As house prices fall consumers have less confidence to spend. There has also been a worrying increase in unemployment in real estate related jobs, such as construction.

The Credit Crunch

The problems in the US housing market and in particular the subprime mortgage sector soon spread to the rest of the finance system. Many big investment banks and commercial banks had been enthusiastic purchases of these CDOs. Basically, big banks had been refinancing these risky mortgage loans. When mortgage defaults started to occur, the commercial banks realised they were facing huge losses. Their losses were exaggerated by the risky nature of the loans. Some hedge funds collapsed completely. Despite the magnitude of the defaults, many of the big banks could afford to write off billions of pounds and still remain solvent.

However, the experience left Wall Street and the global finance system realising the dangers of risky lending. Therefore, the market sentiment changed to one of great conservatism. Banks were reluctant to lend to anyone, even each other and usually secure lending. This led to a shortage of funds in the money markets (such as interbank lending). This credit crunch is basically about a shortage of liquidity in the finance sector. The effects are that ordinary borrowing becomes more expensive and more difficult. Both the UK and US have seen most ‘subprime’ lending products withdrawn.

The credit crunch has also caused great difficulties for banks such as Northern Rock in UK and Bear Sterns in the US. Basically the banks couldn’t raise enough money on the money markets so had to resort to some kind of rescue package. The concern is that more banks could suffer a similar fate and future bank rescues will be more difficult.

Because of the credit crunch, since July, the monetary authorities have been forced to inject liquidity into the money markets three times to avoid a complete shortage of funds. However, there is no guarantee that the markets won’t keep freezing again.

Effect on Consumers and Economic Growth

Falling house prices, falling confidence, higher costs of borrowing have all contributed to a fall in consumer spending and it is this which is the main factor causing a downturn and likely recession. Furthermore, the credit crunch has caused difficulties for many borrowers, who now struggle to borrow at affordable rates. The US also has very high levels of consumer borrowing, therefore, increased cost of borrowing has caused widespread problems. – although the rate cuts by the Fed have made it less painful, it may still not be enough.

It Gets Worse

On its own the Housing crash and credit crunch would cause serious problems. However, the US economy has other underlying problems which makes it more difficult to deal with the problem.

Devaluing Dollar. In one sense the depreciating dollar is helping to increase exports and maintain growth in the export sector; to some extent this may counter the fall in consumer spending. However, the depreciating dollar is contributing to both cost push inflation and declining living standards. This means the US could face the unpleasant occurrence of both inflation and lower growth. It makes the job of the Fed more difficult; in particular rate cuts further weaken the dollar and increase inflation. At the moment, the Fed have decided the recession is more serious than inflation, and rates have been cut.

Current account deficit. The current account deficit is an indication of an unbalanced economy – too much spending, low savings ratio. A downturn in the economy and depreciation in dollar are necessary to deal with this.

National Debt. The US national debt stands at 65% of GDP, (even more if you include future pension liabilities). This gives the economy little room for expansionary fiscal policy. It means the US pays a lot in debt interest payments and the forthcoming recession will only aggravate the debt situation.

Small story on Economy Bubble or stock market

UNDERSTAND market, assets and bankruptcy concept!!!! Worth reading it to understand Bubbling in economy.

Once there was a little island country. The land of this country was the tiny island itself. The total money in circulation was 2 dollars as there were only two pieces of 1 dollar coins circulating around.

1) There were 3 citizens living on this island country.  A owned the land. B and C each owned 1 dollar.

2) B decided to purchase the land from A for 1 dollar. So, now A and C own 1 dollar each while B owned a piece of land that is worth 1 dollar.

* The net asset of the country now = 3 dollars.

3) Now C thought that since there is only one piece of land in the country, and land is non producible asset, its value must definitely go up. So, he borrowed 1 dollar from A, and together with his own 1 dollar, he bought the land from B for 2 dollars.

*A has a loan to C of 1 dollar, so his net asset is 1 dollar.
* B sold his land and got 2 dollars, so his net asset is 2 dollars.
* C owned the piece of land worth 2 dollars but with his 1 dollar debt to A, his net residual asset is 1 dollar.
* Thus, the net asset of the country = 4 dollars.

4) A saw that the land he once owned has risen in value. He regretted having sold it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollars from B and acquired the land back from C for 3 dollars. The payment is by 2 dollars cash (which he borrowed) and cancellation of the 1 dollar loan to C. As a result, A now owned a piece of land that is worth 3 dollars. But since he owed B 2 dollars, his net asset is 1 dollar.

* B loaned 2 dollars to A. So his net asset is 2 dollars.
* C now has the 2 coins. His net asset is also 2 dollars.
* The net asset of the country = 5 dollars. A bubble is building up.

(5) B saw that the value of land kept rising. He also wanted to own the land. So he bought the land from A for 4 dollars. The payment is by borrowing 2 dollars from C, and cancellation of his 2 dollars loan to A.

* As a result, A has got his debt cleared and he got the 2 coins. His net asset is 2 dollars.
* B owned a piece of land that is worth 4 dollars, but since he has a debt of 2 dollars with C, his net Asset is 2 dollars.
* C loaned 2 dollars to B, so his net asset is 2 dollars.

* The net asset of the country = 6 dollars; even though, the country has only one piece of land and 2 Dollars in circulation.

(6) Everybody has made money and everybody felt happy and prosperous.

(7) One day an evil wind blew, and an evil thought came to C’s mind. “Hey, what if the land price stop going up, how could B repay my loan. There is only 2 dollars in circulation, and, I think after all the land that B owns is worth at most only 1 dollar, and no more.”

(8) A also thought the same way.

(9) Nobody wanted to buy land anymore.

* So, in the end, A owns the 2 dollar coins, his net asset is 2 dollars.
* B owed C 2 dollars and the land he owned which he thought worth 4 dollars is now 1 dollar. So his net asset is only 1 dollar.
* C has a loan of 2 dollars to B. But it is a bad debt. Although his net asset is still 2 dollars, his Heart is palpitating.
* The net asset of the country = 3 dollars again.

(10) So, who has stolen the 3 dollars from the country ? Of course, before the bubble burst B thought his land was worth 4 dollars. Actually, right before the collapse, the net asset of the country was 6 dollars on paper. B’s net asset is still 2 dollars, his heart is palpitating.

(11) B had no choice but to declare bankruptcy. C as to relinquish his 2 dollars bad debt to B, but in return he acquired the land which is worth 1 dollar now.

* A owns the 2 coins, his net asset is 2 dollars.
* B is bankrupt, his net asset is 0 dollar. ( he lost everything )
* C got no choice but end up with a land worth only 1 dollar

* The net asset of the country = 3 dollars.

************ **End of the story; BUT ************ ********* ******

There is however a redistribution of wealth.
A is the winner, B is the loser, C is lucky that he is spared.
A few points worth noting –

(1) When a bubble is building up, the debt of individuals to one another in a country is also building up.
(2) This story of the island is a closed system whereby there is no other country and hence no foreign debt. The worth of the asset can only be calculated using the island’s own currency. Hence, there is no net loss.
(3) An over-damped system is assumed when the bubble burst, meaning the land’s value did not go down to below 1 dollar.
(4) When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the losers. The asset could shrink or in worst case, they go bankrupt.
(5) If there is another citizen D either holding a dollar or another piece of land but refrains from taking part in the game,  he will neither win nor lose. But he will see the value of his money or land go up and down like a see saw.
(6) When the bubble was in the growing phase, everybody made money..
(7) If you are smart and know that you are living in a growing bubble, it is worthwhile to borrow money (like A ) and take part in the game. But you must know when you should change everything back to cash.
(8) As in the case of land, the above phenomenon applies to stocks as well.
(9) The actual worth of land or stocks depend largely on psychology.