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House and other property prices in the US shot upwards by nearly sixty percent from the year 2000 to the year 2006 before plummeting downwards and almost hitting the floor in the year 2007 (Roberts, 2008, p. 4). The reason behind this strong growth was due to a huge growth in demand for property to settle in, coupled with limited supply as result of shortage in land especially in developed towns. Competition from the various players in the fragile construction segment also fuelled the rise in house demand. In addition to these, housing demand was stimulated by other unsustainable elements such as excessive expectations in regard to increased house prices, easily available mortgage services and a very friendly monetary policy (Roberts, 2008, p. 13). However, there are many questions that were put forward as to what led to the collapse in real estate, a phenomenon referred to as bursting of the housing bubble. The major reason that has been put forward is that greed (Thomsett, 2007, p.152) is the underlying reasons as to why the housing bubble burst.
Frank Ahrens defined the housing bubble to be like a gold rush where a lot of people were trying to make money quickly through betting with a hope that an asset was going to be valuable on a future date (Droke, 2005, p. 101). It happens when an item’s price is bloated and is more than the real value of the item. A typical house price is about four times the disposable income of a person. Bearing this in mind, before the bursting of the bubble in 2006, the sell-price was 5.2 times the disposable income on a given individual which was by far overprice compared to the actual value (OECD, 2008, p. 26). This inflation led to the bursting of the real estate market, prices of houses continuously increasing until potential buyers could not afford the prices (Thomsett, 2007, p.152). This collapse can also be attributed to agents who were trained to sell to house buyers the most expensive house they could afford. With just additional payment, a buyer could get a larger home. With the agents being paid on commission, the increase in home prices meant that they (agents) took home a handsome amount and thus their greed came into play in bursting of this bubble. Another player in this mess was the mortgage lenders, who in the years that preceded the bursting of the housing estate bubble used a risky marketing strategy that comprised of low mortgage rates that were supposed to tease the buyers into borrowing. Some of these risky mortgages had adjustable mortgage rates with little or no initial interest rates, a tactic that lured many unsuspecting homebuyers into borrowing. This is because many of these home buyers believed that they were going to own their dream houses in addition to being able to own them (Thomsett, 2007, p.153). These mortgages were then calculated using introductory rates used to value the homes thus many people could afford their dream houses. However, to the shock of the owners, the low interest or no interest rates on the loans applied for a short time and the affordability phenomenon was cast aside. The repayment to these loans jumped to unaffordable levels once the initial payment time was up, making the once “affordable” houses become a nightmare to the prospective owners. The disclosures that were supposed to clarify the terms of the loans were neither explained to nor well understood by the prospective home buyers (Droke, 2005, p. 106). This was a form of greed that was orchestrated by the banking industry in order for them to reap maximum profits from the teaser mortgage rates.
The fall in house prices began to bite in the middle of the year 2007 in America (OECD, 2008, p. 30). This cycle in which there was a bloom in house prices then plunging down was experienced back during the era of Second World War. Financial institutions such as banks that were offering very low and unrealistic loans on real estate are doomed to lead to the collapsing of tax systems or lead to a bailout of the taxpayer system that will worsen the current deficit further into some form of financial quagmire. Institutions that have adjustable mortgage rates will find it impossible to honour their loan repayment and there is a greater likelihood of defaulting. The result of this is that foreclosed houses will have to be flooded into the market that in turn will bring into collapse the value of homes. The collapse in the real estate will in turn lead to inflationary depressions in the world’s large economies such as the United States that rely heavily on credit buying of homes. It is therefore important to grasp and understand the relationship between the banks and the real estate in order to prevent future financial crisis that may occur. In the event that it does happen, there will be proper mechanisms in place to ensure that the economies have graceful recovery to normalcy (Droke, 2005, p. 108). Further understanding of the real estate cycle will enable future home owners to understand how to value their homes as well as know the best mortgage for them to apply.
The boom in the real estate led to loans concentration in the real estate sector in which the amount lent out compared to the capital was greater than the expected opportunity cost of funds (Grossman 2010, p. 269). Banks opted to venture into loaning real investors because the sector appeared to be very attractive and, thus, profitable as direct result of interest rates charged on the loans. The promised returns which not only included the contractual interest on these loans but also other fees that were stated in interest equivalent form, were higher than rates that were often in the prime corporate loans. The exponential burst of bank lending occurred when banks were awarded extended powers which were partly supposed to help the banks to increase their profits in order to compete with financial firms that were heavily regulated effectively. The upward trend in real estate prices encouraged lending to real estate investors in two ways. To begin with, the bank’s real estate holdings shot upwards in value which led to the increase in bank’s capital economic value that led to the bank’s willingness to get hold more real estate through loans. The second way arose due to the increase in market value of outstanding real estate loans collateral, which boosted the confidence of the loaners since the risks of losses on the existing loans portfolio had declined and, therefore, there was a possibility for lending more money on top existing loans without increasing the chances of the loaners getting into bankruptcy. The increase in prices in real estate could have had a more cushioning effect on the subjective probability of a default which was applied by banks to a new lending into real estate. In spite of these factors that led to boom in the attractiveness in real estate landing, it can be clearly and without a reasonable doubt that these lending banks failed to assess in details the risks involved in such lending.
In most cases, the real estate prices had a steady increase through a significant period which made the repayment track record on loans to real estate be exemplary good compared to other types of lending. Rush and uncertain decisions were made as result of underestimating the slow frequency shocks arising from the illusion that real estate sector was the best performer in terms of loans and repayment record. However, the ability to project that there was the possibility of a shock such as the collapse in real estate depended on two key factors. The first factor is due to the rate at which the shock takes place in comparison to how the frequency changes with the causal underlying structure. In a scenario where the structure changes with every shock that takes place, then the subsequent events cannot give rise to proper evidence that showed the probabilities. On the other, if the structures remained stable with each time a shock occurred (Grossman 2010, p. 223), then the probabilities may be obtained with high degree of confidence. It has been shown that shocks that occur in high frequency have been seen to have great effects on the kind of activities that are conducted by the banks. To illustrate this as an example, credit card receivable default rates or bank deposit withdrawals done routinely can be estimated with a degree of certainty which goes to show that high frequency shocks are not pose risks of exposing banks to insolvency. This is because the banks have the insight and incentive to such value these high frequency shocks in the right way which in the long run buffers then against any prospects of losses. Such banks that lack such a mechanism run at a risk of making heavy losses and driving into insolvency.
However, the underlying low frequency causal structure of economic shocks which may result from speculative bubbles, changes in policy regimes or abrupt changes in prices may not be stable for sufficiently long time to allow projection of shock probability with degree of certainty (Gordon 1990, pp. 14-16). If the banks then have the insight into the ways of predicting outcomes, them they could have determined empirically the amount of evidence that would have showed them the outcome of such investments in real estate. It was hard for people to use formulae and predict that real estate was going to collapse given the vigour it had grown with and the confidence it had won over the banks with. It can be deemed that the understanding of economic activities that give rise to such shocks is far less comprehendible which increases its chances of being subject to uncertainty. The main question that would have been asked is the process through which banks came up with decisions regarding such low frequency shocks. One explanation brought about is that the human nature of the managers in the banking sector made them see that the luxurious real estate was not in of reduction in price. They focused on the high frequency events but failed to take note of other factors until it was somehow too late to salvage the ship. The illusion of high profits created the problems in which salaries and bonuses were based on the short term profits that did not take into account the adjustments for reserves to cushion (Asli et al. 2011, p. 10) against the shocks, while high level corruption saw the people tasked to point out such flaws paid in order to disregard the proper proposals.
Banks could have also underestimated the risks involved in their heavy concentration to loaning the real sector as a direct result of weak risk analysis and inadequate information being released with regard to such risks. Estimating the present value of real estate projects proved to be a daunting task, due to dynamic factors in the market. As explained by Galaty et al. (2003, pp. 236-240), such factors depended on the projected rents and the projected discount rates that had been adjusted to cater for inflation as well as loss in value of the property that arose from functional and/or physical depreciation arising due to competing properties or as result of the cost of developing the property. The banks did not take into consideration that some of the property had been overvalued and their true value was to reflect later. Unfortunately, banks had difficulties in obtaining some markets data in regard to building permits, rents, new construction contracts, vacancy rates and market prices and also verifying them. That notwithstanding, the banks should have made efforts to find the present values of such property and use it to benchmark with other property valuation methods such as appraisals based on comparisons from other properties that had similar characteristics. However, appraisals were on their part not the best tool the lenders could have since it showed the past value of the prices and not the present values over which such a loan given on that property would be serviced. Appraisals were also subjected to effect from distortion of market prices.
Credit crunch that is being experienced in economies such as the US has been a result of the real estate housing bubble whose impacts and effects have spread throughout the entire globe (Hynson, 2010, p. 44). Most of affected economies have tried in vain to instigate coordinated, dramatic and drastic interest rates cuts, tried also to infuse huge amounts of cash into as well as nationalizing banks, but still the credit of the world still remains crunched and at the brink of collapse. As seen, this crunch has been as a direct result of the mortgage market, where there is direct relationship between the mortgage market crash and the worldwide credit crunch. This has resulted from the prospective homebuyers seeking loans from the Banking sector and/or non banks who in turn take their credit from International Bank Lenders (IBL) in addition to Mortgage Funds. The bank and non bank lenders then utilise the money received to grant loans to these prospective home owners. From the developments of recent past, it has been noted only that very few of the home buyers given loans turned back and repaid the loans to the lenders. From these discussions, we clearly see how the booming real estate and its subsequent collapse led to the weakening of the banking system. In spite of this, real estate remains a formidable force in the economy of the word. The recent collapse in real estate markets in the developed countries marked the culmination of one cycle, while at the same time marking the start of another cycle. Real is estate is going to rise, but it is the belief of everyone in the world that this time round, the stakeholders in the bank industry will be wiser on whom to extend their credit services.