Introduction
A bond price is the total amount of money paid to purchase a bond. The prices of bonds are negatively related to interest rates meaning that as interest rates increase, the bond prices will fall and when interest rates fall, the bond prices will increase. When interest rates rise, the rise puts an upward pressure on the cost of borrowing. It therefore becomes more expensive to borrow funds. As a result, the demand for bonds will fall forcing their prices to fall as well. On the other hand when interest rates fall, the cost of borrowing also falls. It therefore becomes cheaper to borrow money. As a result, the demand for bonds will rise which will in turn push their prices up. The sale of bonds is one measure used by governments and businesses to raise money. The relationship between the price of bonds and interest rates implies that Bond prices are affected by many economic sectors and activities. The aim of this paper is to discuss the effect of the United States’ sub-prime mortgage sector on bond prices.
The US sub-prime mortgage market
Since, the private sector had principally prolonged its function in the mortgage housing market, which had until that time been under control of government-sponsored institutions such as Freddie Mac. The private companies focused on innovative types of mortgages, particularly the sub-prime lending to borrowers who had meager credit records and feeble certification of income. These borrowers had been rejected by the prime lenders such as Freddie Mac. Sub-prime lending gained momentum in the US housing market and by 2005 it had extended from inner-city regions throughout the nation. By then, the proportion of sup-prime lending companies in the total market stood at 20 percent, and they were predominantly well-liked among new immigrants who were trying without much progress to purchase a residence for the first time in the popular housing markets such as Northern California, Arizona and Washington, DC (Brenner, 2003). The risk involved in sub-prime lending is great not just for the lenders but for the borrower as well. This is because the conditions are too lenient and majority of people including those of low-income brackets can gain access to the loans offered. As a result, the sub-prime loans were granted at higher interest rates than the comparable prime loans. The higher interest rates were intended to cater for the great risk associated with the loans. The high interest rates were to provide higher returns for the lenders to compensate them for the high risks. The introduction of the sub-prime lending created a high demand for houses across the US which in turn increased the prices of houses leading to the housing bubble that is commonly blamed for the recent global credit crunch.
The American economic condition during the housing bubble
When the housing bubble began, the performance of finance in the United States was most impressive. With the exception of the economic downturn year of 1998, financial profits had, from the mid-1990s, benefited from a practically unbroken record of increase, and in the first quarter of 2003 they were in excess of 35 percent beyond their level of 1996. Spending among consumers, founded to a great extent on household borrowing against home equity, as well as the increasing housing prices, had pushed the demand for retail trade, wholesale trade and other services upward. Profits resulting greatly from mortgage associated business, in addition to the trading and underwriting of bonds – all a result of falling interest rates – made it possible for the banks and other financial institutions to keep on attaining considerably growing prosperity. The economic growth was fuelled chiefly by the debt-reliant consumption and growing bubbles that were as a result of the government’s reduced rates of interest and growing deficits. This was regardless of the massive decline in the prices of equity and huge decreases in the growth of corporate borrowing. The fragile economic situation forced the US government to take drastic measures to avoid the possibility of collapse. Staring from the mid-2000 and continuing till the early 2003, the Federal Reserve reduced the interest rates on its short term loans from 6.5% to 1%. The interest rate was further reduced from 1% to 0.25% in June 2003. During the same period, the fiscal state of the US government shifted from a surplus of 1.4 percent to an anticipated deficit of 4 percent of gross domestic product.
During the first six months of 2003, the interest rates on long term loans had fallen to levels that were comparable to the period following the Second World War. The economy continued to perform badly, and the growth of sub-prime investors interested in high risky ventures soared. The government during this time kept its promise of keeping the cost of borrowing down pending the end of the deflation. This it did by maintaining low rates of interests. The result of all these measures was the blowing up of the bond market bubble (Consigli, MacLean, and Zhao, 2009). However when, seemingly in the center of an escalating crusade to stop falling prices, the Fed abruptly exposed its conviction that the economic position was improving, the previously over-purchased bond market viciously overturned itself, and interest rates on the long term loans increased significantly to a level not experienced for a long time. The concern was that this was only the start and the rates of interest would not only additionally rectify themselves, but also they would keep on rising, as the more speedy increase of demand led to higher prices and a higher demand for loans. If this had happened, the housing bubble would have ceased to and the mortgage equity extraction would have begun to fall. This would have gravely diluted the enduring high consumption levels that had fuelled the economy since the end of 2000 (Brenner, 2003, p.310).
The bond market conundrum
The bond market conundrum refers to “the failure of longer-term interest rates to respond to changes in the Federal funds rate in the normal fashion,” (Iley and Lewis, 2007, p.67). The bond market conundrum was one of the signs of the low inflation-adjusted rates of interest. The surfacing of this condition in the US began in the era from mid-2004, when the Federal Reserve began the lengthy procedure of eradicating surplus monetary relief and stabilizing the level of policy rates. This condition has to some degree hindered policy-makers in trying to lessen the costs or permanent effect of the deflation insurance measures on the American economy (Iley and Lewis, 2007).
Bond prices during and after the burst of the housing bubble
The prices of bonds fluctuated significantly before, during and after the housing bubble in reaction to the changes in interest rates adopted by the government. Iley and Lewis (2007) argue that, “In the six tightening cycles preceding the 2004-2006 episode, the yield on the 10-year Treasury note was on average almost 100 basis points (where 100bp equals 100% point) higher after one year,” (p.67). By the middle of 2005, the yields on the 10-year Treasury note were 70bp lesser than at the beginning of the tightening policy. It was not until mid-2006, with the Federal funds rate increased by 425bp to 5.26% that yields on the 10-year T-note lastly shifted up by 60bp two years following the beginning of the tightening policy. However, the yield on the 10-year note declined in the second half of 2006, at last concluding the year at 4.40%, 7bp more than the 2005 close of 4.33% (Iley and Lewis, 2007).
Conclusion
The Federal Reserve in 2006 executed its final three 25bp rate increases, with the last rate increase to 5.25% occurring in June 2006. In 2004-06 the Fed increased its federal funds rate goal by a total of 425bp from the 1% level that had existed beginning in mid-2003 to mid-2004 to 5.25% by June 2006. The tightening of the monetary policy by the Fed was also done during the same time period to shift the interest rates on short-term loans back to standardized levels after the Fed was forced to reduce the funds rate in 2001-2003 to 1% to tackle the economic challenges caused by the stock market burst. The possibility of the bursting of the housing bubble forced the Fed to finally halt its tightening regime in mid-2006.
Reference List
Brenner, R. (2003). The boom and the bubble: the US in the world economy. New York: Verso.
Consigli, G., MacLean, L.C. and Zhao, Y. (2009). The bond-stock yield differential as a risk indicator in financial markets. The Journal of Risk, 11(3), 3-24.
Iley, R. and Lewis, M. (2007). Untangling the US deficit: Evaluating causes, cures and global imbalances. London: Edward Elgar Publishing.