The world is just recovering from an economic crisis that saw some of the world’s largest economies struggle to forestall looming crashes. Financial, and other, institutions were crumbling under the weight of one of the worst economic crises since the Great Depression of the 1930s. In the United States, automakers, banks and insurance companies, mortgage companies, stock exchanges, and other sectors were performing so badly that they had to seek rescue aid from the federal government. One of the sectors hit hardest by the crisis was the housing sub-sector. Millions of Americans could not meet their regular mortgage payment obligations and house prices were falling sharply as thousands of Americans tried to sell their houses. In an attempt to rescue the sub-sector, US President Barrack Obama embarked on a rescue plan to help to default mortgage payers honor their obligations and retain their houses. The rescue plan was encountered with a lot of resistance from part of the senate and interested parties. This paper focuses on the impact of the banking bail-out on the housing sector.
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US bail-out and Banking industry
The banking industry bore the heaviest brunt of the global economic crisis. Industries were collapsing at alarming rates and unemployment rates across the country were equally worrying. The situation spelled a disaster for the banking industry. It meant lower deposits, high-interest rates, little inter-banks borrowing, and hefty withdrawals. The industry was thus headed for a mighty and sure crash. As expected, the government liquidity provider (the Federal Reserve) stepped in as the lender of last resort (Ashcraft, Bech & Frame 2). Given the irreplaceability and importance of the industry to the economy, the US administration picked the banking industry as one of those meant to be rescued through a multi-billion stimulus package. Other industries selected for rescue included automakers and mortgage lenders.
The housing sector is one of the most important sectors of many a developed and developing economy. The importance of housing has been viewed from three dimensions. First, housing is a critical element of the construction sector. Secondly, housing is an indispensable part of the real estate market, a resilient and fast-growing element of many economies. Lastly, housing purchase plans (mortgages) have become an important part of the banking sector. Banks now compete to develop mortgage products that are better than their competitors’ as demand for more housing intensifies, thereby promoting financial innovation. Housing also plays crucial political and social roles, making the housing sector a sensitive one (Sassen 189). Thus, having assessed the effect of the economic crisis, President Obama’s administration prioritized housing as one of the sectors in dire need of emergency rescue as mortgage lenders were incurring huge losses and the housing-market landscape deteriorated (Federal Reserve Bank of Cleveland 20).
Speculation and “carelessness” under the Clinton and Bush administrations had led to massive inflation of house prices and had seen the number of people defaulting on their mortgage payments rise gradually. The majority of Americans had been paying the regular mortgage payments on time before the crisis hit the world. According to The New American (40), approximately “92 percent of the first mortgages were being paid on time at the end of 2007.” Convinced that the gravity of the economic crisis was reaching critical levels, the Senate approved a multi-billion rescue package which included tax breaks for homeowners and builders, and grants for Americans to rehabilitate property which had been foreclosed (The New American 40). The stimulus package was meant to redeem confidence in the wobbly financial system and to help banks to start lending to individuals as well as to other banks again (BBC).
Effect of bank bail-outs on the housing market
When the government agreed to buy the bad mortgages from the mortgage-lenders, it was predictable that banks would get the incentive to lower inter-bank lending rates and would not be reluctant to lend to other banks or to borrow from other banks for fear of incurring losses. Had it not been for the stimulus package, many banks would have been unable to access cash from deposits and loans.
Additionally, the rescue package also motivated banks to reduce interest rates and revise their mortgage terms with homebuyers to give them time to clear their mortgages. The economic crises caused the values of houses to decline sharply, meaning that homeowners who were still paying their regular mortgage installments found themselves in a situation where their houses were worth much less than the amount of money they were paying in mortgages (Joint Center for Housing Studies of Harvard University 1). Mortgage lenders responded by tightening mortgage terms to reduce the risk of underwriting bad mortgages. It was thus important that the federal government steps in and reconciles the mortgage lenders and the borrowing population or the home-buyers. According to Jacobs & Zibel, lenders and mortgage lenders seeking the bail-outs had to commit to taking not more than 38 percent of their borrowers’ pretax incomes in mortgage payments. The bail-outs thus helped keep the housing market alive as more people could pay their mortgages on time, compared to a much smaller number which could have afforded to make the regular payments without the bail-outs. It is worth noting that the economic crisis came hot on the heels of a housing construction boom in the US which had led to the supply of housing outweighing the demand for the same (Ellis 3). By helping stem the numbers of property foreclosures, provision of the banking bail-outs ensured that property value in the neighborhoods where some homes were foreclosed did not decline as rapidly as it would have declined without the stimulus.
On the flip side, the bail-outs ensured that property retained its value, meaning that houses could retain artificially high value. This can be attributed to the housing construction boom preceding the recession. During the boom, speculation had soared as Americans rushed to acquire houses in locations that showed the highest possibilities of gaining value rapidly at which point they would sell the houses to make massive profits. Mehring noted that increased speculative activity was evident from the increasing numbers of Americans seeking loans for second homes. Most of these homes were found in states where housing sales volumes were highest during the housing boom. Favorite states included Arizona, California, Florida, Hawaii, Idaho, Nevada, New Mexico, and Oregon. Loose and almost casual mortgage lending terms motivated more people to get into house-buying agreements with abandon. The mortgage lenders required “little or no proof of income; others needed little or no down payment.” Homebuyers were also allowed to get loans for more than one house simultaneously (DiMartino & Duca 2). Some houses, depending on where they were located, were thus sold at inflated prices for speculation purposes. Foreclosure would have brought the houses down to their market prices. The stimulus program ensured that property value did not decline sharply, and their indebted owners kept and paid for the houses at inflated prices.
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Secondly, the stimulus package also helped to prevent the demand for houses from collapsing. The recession had shaken the economy badly and the housing market was seeing falling property value. Job cuts and pay cuts were rampant meaning that more and more people were earning less than before. As noted above, the US housing market was characterized by an oversupply of housing which outstripped demand. The recession could only worsen the condition through declining demand for housing. The banking bail-outs, and the consequent lower interest rates and tax breaks for first home-owners provided the incentive for non-home-owners who still had their jobs to negotiate mortgages for their first homes at a time when mortgage lenders were willing to give the incentive to willing home-buyers. This package favored subprime mortgage-borrowers whose little incomes meant that their loans were a risk to the mortgage lenders. With the support from the government, the banks had the money to support the house purchases of this significant part of the American society. In 2007, subprime mortgages accounted for 14 percent of the total mortgages registered in the United States (DiMartino & Duca 2).
The US banking bail-outs elicited spirited criticism and resistance from thousands of Americans who argued that such action would be tantamount to rewarding greed and unprofessionalism. To the critics, the economic bust was the result of immense greed on the part of financial institutions and mortgage lenders. It was thus immoral to force tax-paying citizens to pay for the sins of the greedy minority.
However, the stimulus package breathed life into the housing market which was faced with deep challenges as a result of the combination of declining property value and a bad economic situation. The stimulus ensured that property value did not collapse, giving the much-needed incentive for home-buyers to continue paying their mortgage dues. It also ensured that demand for housing did not collapse. The bail-outs ensured that mortgage lenders had access to capital and could thus lend to more home-buyers, thereby keeping the demand side alive.
Ashcraft, Arnold., Bech, Masy. & Frame, Warety. The Federal Home Loan Bank System: The Lender of Next-to-Last Resort? Working Paper 2009. Federal Reserve Bank of Atlanta.
BBC. US Unveils New $1.5 Trillion Plan. BBC News, 2009. Web.
DiMartino, Darrel. & Duca, John. The Rise and Fall of Subprime Mortgages. Economic Letter, Vol.2, 2007.
Ellis, Liang. The Housing Meltdown: Why did it Happen in the United States? BIS Working PapersNo. 259. Basel, Switzerland: Bank of International Settlements. 2008.
Federal Reserve Bank of Cleveland. Banking and Financial Industry: Housing and the Banking Industry. Economic Trends, 2008.
Jacobs, S. & Zibel, A. Bailout for Homeowners Stirs up Strong Feelings. Brattleboro, Vt.: The Brattleboro Reformer, 2009.
Joint Center for Housing Studies of Harvard University. The State of the Nation’s Housing 2008. Harvard Kennedy School: Graduate School of Design.
Mehring, Jerring. Housing Speculators are Ready to Bail. BusinessWeek, 2007. Issue 4054.
Sassen, Simon. Mortgage Capital and its Particularities: A New Frontier for Global Finance. Journal of International Affairs, Vol. 62, 2008.
The New American. More Tax Dollars to Bail Out the Housing Mess. The New American 2008.