House Price Expectations and Market Frictions - Example

Property and Construction Market Fluctuations and Instability Are Driven Primarily By Irrational Exuberance College Table of Contents 1.0 What was the Global Financial Crisis?......................................................................................3 2.0 Introduction……………………………………………………………………..……………3 3.1 Role of Financial Innovation…………………………………..…………………………4 3.2 The Rise of Over –Optimism…………………………………………………………….7 4.0 Sources of Liquidity during the Boom……………………………………………………….9 5.0 House Price Expectations and Market Frictions……………………………………………..10 6.0 Irrational Exuberance in the Housing Market………………………………………………..10 7.0 Loose Underwriting principles…………………………………………..…………………..12 8.0 Lax attitude by the Regulators…………………………………………….…………………13 9.0 Consumer Behavior after the 2008 Financial Crisis…………………………………………14 11.0 Reference List……………………………………………………………..………………..15 Introduction This report will attempt to analyze the U.S housing and mortgage market in the period before the Global financial crisis and after the crisis. It will take a look at how periods of irresponsibility and irrational exuberance by the key players of the housing market; home owners and mortgage providers contributed to the implosion of the U.S housing bubble as and the ensuing ripple effect that affected many other housing and stock markets across the globe 1.0 What was the Global Financial Crisis? The global financial crisis is widely believed to have begun in mid-2007 with the onset of the credit crunch. This credit crunch was mainly caused by a loss of confidence in sun-prime mortgages by Investors in the U.S (Baddeley, 2009). This lead to a liquidity crisis which forced the U.S federal Bank to inject massive amounts of money into the markets to ease the liquidity crisis. The situation got even worse by September of 2008 when the global stock markets crashed and became increasingly volatile. This greatly affected consumer confidence in the stock markets which led to a down ward spiral of the stock markets. 2.0 Introduction The sudden collapse of the housing market in a several major economies like Ireland, Spain and the United states led to huge negative repercussions in the economy. We also have to understand that house prices mostly ride on the rational beliefs formed by the home buyers on the fundamentals at play (Wood, 1998). Whenever these beliefs start bordering on the irrational, it is only a matter of time before the incorrect housing prices begin correcting themselves. The graph below shows the U.S housing market trends before the 2007 crisis and collapse of the same thereafter. Source (U.S Census Bureau) 3.0 Factors Contributing to the Boom and Eventual Burst of the U.S Housing Bubble The boom and eventual burst of the Sub-prime mortgages in the U.S has many characteristics of the kinds of financial bubbles that were written by Aliber and Kindleberger (2005). These characteristics were as follows: Latest innovations in the market usually work well in the beginning leading to better than normal yields There is bound to be exaggerated optimism on these returns which will lead to more than anticipated investment in this latest product spurring large increases in the prices of assets in question These characteristics cannot act alone as they only thrive in a financial system with a high liquidity level. The proponent of this new system make use of the past as a guide leading to amplification of the increase in investments appreciation of prices of the asset in question When all these factors come into play, it leads to a development of a price bubble in reference r this asset. The bubble comes to burst when an event occurs that triggers a reassessment of the new prices downwards leading to an unwinding of the exaggerated optimism. In the U.S, there was the practice of noise and momentum trading which played a significant role in the building up of the housing bubble which was further helped by increased expectation formation that was concealed with the market inefficiency (Barkham, 2012). 3.1 Role of Financial Innovation In the mid-1990s, credit worthy borrowers in the U.S had banks advance them conventional mortgages. These banks held these loans in their books and used deposits to fund them. The Government Sponsored Enterprises (GSEs) converted these loans to residential mortgage-backed securities (RMBS) that were funded using the GSE’s debts or by having investors buy them. These were also insured against mortgage defaults. The fact that GSEs were U.S government backed gave the investors’ confidence to purchase these RMBSs as they had a very minimal default risk. Additionally, the Federal Housing Administration gave loans to non-prime borrowers who were required to provide a small down payment to act as an insurance premium which also had the effect of limiting debt service ratios (Barkham, 1999). The FHA had limits on the sizes of loans. This meant that compared to the wider pool of loans in the pre-subprime period, the FHA loans were quite minimal in number. However, subprime mortgages gained a foothold in the pre-crisis era. This was mainly due to the fact that private firms had become increasingly active in the market and were offering a more lax limit on debt service as well as loan to value ratios. By the year 2006, their share stood at about 40% of the entire mortgage market. Credit scoring technology was eventually introduced which enabled lenders to identify correctly sub-prime applicants and hence price the risk appropriately. This however created a new sort of problem. They still accepted the subprime loans but were in a dilemma as to how to fund them as they were too risky to be held by regulated banks in their books. These high risk mortgages could expose the investors to uncertain default risks if they were to be packaged like homogenous securities (Hillebrandt, 1985). Graph Showing Ratio of Impaired Securities 3.2 The Rise of Over –Optimism Most players in the housing industry based their analysis on very short history of the housing market. This made it almost difficult to forecast the impending losses due to the subprime mortgage defaults (Summer, Minsky, Samuelson, Poole and Volck, 1991). A good example can be seen with the Mortgage Bankers’ Association data series which had a database that ran only up to 1998 (Ive and Gruneberg 2000). This data contained the past due dates for subprime loans experiences a steep rise when approaching the recession in 2001. However, as the economy recovered this reduced rapidly from 2002 through to 2005. This behavior of the data indicated that the past due date would remain low as long as there was continued growth in the Job market (Romer, 1994). This model that links risk to growth in the job market manages to ignore other factors that played a part in reducing due rates in the 2002-2005 period. It should be noted interest rates reduced in the beginning of 2000 therefore lowering the base lending rate which is used in resetting subprime mortgage rates. This helped in stabilizing the average rates upon the expiry of the teaser interest rates. Graph Showing Mortgage rates in response to Jobs data There was also rapid increase in house prices which made it easier for troubled borrowers to either dispose of their houses and finish off the mortgage or deal with late payment problems by borrowing more on the same house. The was far greater fluctuation in foreclosure rates after 2006 due to the fact that the swing in house prices was much greater than had been earlier on anticipated. It was even higher for subprime mortgages since the home values were plummeting way below the mortgage principle levels giving them a much higher incentive to default. In 2006, interest rates began rising while at the same time the market experienced a drop in house prices. This led to a steep increase in the past due rate on mortgages despite the fact that the U.S economy was experiencing continued job growth. Even though the job growth model seemed to track subprime due rates perfectly in the mid-2000s, it was not so the case as it generated a very unreliable out-of-sample statistic forecast in 2006-2008. 4.0 Sources of Liquidity during the Boom The cuts in short-term real interest rates to zero in the 2003/04 period contributed to the subprime property bubble. (Leamer, 2007 & Taylor, 2009) The fed did almost the same thing in the 1992/3 period and there was no such property bubble to speak of. It is even more puzzling when we realize that consumption and housing were much stronger in 2000 than predicted by the conventional models. This unexplainable boom came with huge surges in refinancing activity and mortgage equity withdrawals (MEW) which was especially high during the 2001 high-tech recession. A much more balance model that seeks to explain the subprime bubble shows that low interest rates , a relaxation of mortgage credit standards and a growth in the ability to have a piece of housing wealth led to an a general increase in household spending. The downside to this was that this extra borrowing was funded by securities issuance as opposed to the conventional increase in money supply. Some were of the view that huge inflows of capital from the China into the U.S was behind the relaxation of credit standards and the subsequent increase in structured financial products and securitization (Corden, 2009). 5.0 Irrational Exuberance in the Housing Market The recent U.S housing bubble defied the basic laws of economics. Demand and supply of houses were rising simultaneously. The housing market rose to immoral heights before it eventually crashed to hit historic lows .It swung from an extreme state whereby it was very easy to sell a house regardless of how high the set price was to the complete opposite whereby the same houses hit rock bottom prices but they still could not attract a buyer. We are taught in classrooms that if the free market is left alone, it will regulate itself and set the correct prices for every asset on the market. If this was true, then bubbles would not develop in the economy leading to alternating periods of boom and burst. In the 1990’s the economy was growing at a reasonable rate. Construction industry was expanding as well as house prices in this sector (McGough and Tsolacos 1997). However, towards the end of the decade, these sensible solid investments were getting replaced with speculation in the market. This led to a sharp unprecedented rise in prices which was also accompanied with a rise in sales figures in the housing industry .The general population was gripped by overconfidence and irrational exuberance. This played a part in raising the confidence levels of both investors and individuals. The overconfidence in investors also increased their appetite for greater risk that translated to bigger rewards. Suddenly everyone saw a shortcut in achieving the previously elusive American dream. This unfortunately was the undoing of the market as irresponsible bankers extended mortgages to individuals who clearly could not afford them which led to the subprime crisis. Various factors are responsible for price changes in a conventional housing market. The number of vacant homes in the market will tend to apply to increase or reduce pressure on house prices. A vacancy rate can be defined as a proportion of the total house inventory that has remained vacant in the market after going on sale. The average vacancy rate in the U.S stood at about 1.4% from 1965 up to 2004 (Ive and Gruneberg, 2000). This rate however shot up during the crisis period in 2008. It stood at a staggering 3% (Census Bureau). This created a spiral effect since the increased downward pressure on the home prices gave the incentive to many subprime owners to default on payment leading t foreclosures that consequently increased the vacancy rates in the market further pushing the prices down. Graph showing house prices before and during the crisis We can employ the theories from the labor market to attempt at explaining the house price fluctuations in the U.S market. The search and matching models can be appropriate. The number of vacant houses in the market tends to vary over time just like the labor market in regards to wages and availability of qualified individuals to fill the positions on offer. The period of time a developer takes to dispose of the house in the market tends to change over time depending on the market’s dynamics (Wheaton, 1990). Higher vacancy rates in the market significantly increases the sales times and in an attempt to speedily sell the houses, the developers will tend to undercut each other’s prices leading to a gradual reduction of the home prices. The irrational exuberance of home owners and banks always tends to create artificial hot and cold season in the U.S housing market (Ive and Gruneberg, 2000). Whenever there are many buyers and sellers, increased transactions and increasingly high house prices, this is referred to as a hot season. This was the period that preceded the U.S and Global financial crisis. In recent years, there has been a rowing gap between existing and new home sales. This can be attributed to the jump in number of distressed property sales after the implosion of the property bubble in 2007/08. 6.0 Loose Underwriting principles In the late 1990s, there was an increase in supply of capital around the world. All the owners of this excess capital were seeking a place where they can get the best returns on their investment. (Wall Street Journal, 2005) Insurance and mutual funds as well as global pension funds had almost $46trillion in their coffers in 2005. This was almost 33% higher than the figure was just five years earlier. The traditional investments worldwide had unfavorable returns due to the savings glut at the time. This made investors to start shopping around for much more riskier assets that attracted higher returns if and when they pay off . Firms that issued these risky assets stood to benefit greatly as increasingly more money was thrown at these risky assets. The subprime mortgage market provided the suitable outlet for this extra capital that is in search for high returns due to its high yields. This was reflected on its share in the overall mortgage market with its value growing from the 1994 value of 35billion dollars up to $665b in 2005. By 2006, the subprime mortgage market was almost 25% of the entire mortgage market (Shiller, 2008). Wall Street’s appetite for these risky assets grew over the years leading to a watering down of underwriting standards in subprime mortgages. The home equity refinance market was the root of the high-cost subprime mortgage. Subprime lending expanded in the home purchase market when the increasing demand from Wall Street surpassed the supply. This stage led to the increase in popularity of the adjustable rate mortgage. This even included short term teaser rates that would adjust to duly indexed rates in the space of a few years. 7.0 Lax attitude by the Regulators The actions or perceived inaction by the regulators responsible to tame the market was seen as an endorsement by the market players of whatever action they did. The regulators’ actions could be divided into two groups: Encouraging nonconventional mortgages and easy credit. Adopting an attitude that could be referred to as laisserz-faire. The Federal Reserve held the interest rates low which encouraged borrowing of loans across the board leading to excess liquidity that was a key factor in inflating house prices. This reduce interest rate was due to the fact that the government was keen to avoid deflation in the housing market which would have negative consequences on the economy as well. But by avoiding one problem, the government was feeding another one whether unwittingly we may never fully know. The Federal Reserve was also irrational when it encouraged American consumers to apply for more loans hence assuming risk. 8.0 Consumer Behavior after the 2008 Financial Crisis Pew Research Centre conducted a survey between January 2008 and June 2010 covering 2,967 respondents. This study discovered that almost two thirds of the respondents had significantly reduced their spending since the beginning of the financial crisis. Before the financial crisis, living the American dream was depicted by large acquisitions e.g. big house, bigger car than that befits one’s status. This has significantly shifted with almost 67% of American respondents preferring a toned down lifestyle which meant having less possessions and having reduced emphasis on displays of wealth ( Summer, Minsky, Poole & Volcker, 1991). This can mean that unlike the pre-crisis period, consumer spending is not growing quicker than their average personal incomes. Most Americans have begun embracing saving and doing their best to avoid debt. There is a rise in the use of debit cards as more Americans are becoming more conscious about their personal debts and going the extra mile to minimize this. In this post crisis period, impulse consumption is viewed as a weakness on the individual. More people are beginning to value self-sufficiency and resourcefulness which are now viewed as virtues as opposed to the pre-crisis period. The consumer has grown to be more savvy about social media and marketing. This means that enterprises that target these customers need to be much more innovative and always listening on what their preferences are since they are looking for the best value money can buy. Over the past two years, their confidence in big business and government has dipped by about 50%. The drop is especially big in the financial institutions (Kindleberger C et al, 2005). This is due to their perceived reckless behavior that brought about the 2008 financial crisis through their greed and love affair with short cuts. Consumers have also become more attracted to companies that are seen to care about their community impact. 9.0 Consumer Spending after the Financial Crisis Conclusion The housing bubble collapse came as a result of years of unethical practices in the housing market that fed on the artificial bubble to make a quick buck. Everyone was winning during the good times with homes being flipped at astonishing profits. With this kind of attitude and psychological state of players in the housing industry, there came about a lot of carelessness and irrational exuberance in their judgment and decision making process. The regulators turned a blind eye on certain ethics and rules .Choosing not to enforce the rules for fear of ‘choking’ the industry and in the process scaring away much needed investors. They did not foresee the greater damage that a bubble collapse would do to the same industry that they wanted to keep investors happy by being lax on regulation. The developers also did not exhibit investor rationality and jumped on the bandwagon to flood the market with homes many of which were of poor standards due to rushed construction to gain a quick buck. The subprime borrowers punched way beyond their weight by burdening themselves with mortgages that their incomes could not service in case of a sudden change in interest rates. The prevalence of this irrational exuberance on all industry players is in my opinion the sole biggest cause of the global financial crisis. The crisis has brought about much needed changes to the key stakeholders in the market which can only be good in the long term. 10.0 Reference List 1. Baddeley M (2013). Behavioural Economics and Finance, Routledge, London. Chapters 6 and 11. 2. Baddeley M (2009). Running Regressions: a practical guide to quantitative research, Cambridge: Cambridge University Press. Chapter 5. 3. Baddeley M (2005) ‘Housing bubbles, herds and frenzies: evidence from British housing markets’, University of Cambridge, Dept, of Land Economy, Centre for Economic and Public Policy Brief No. 02/05 4. Ball M and Wood A (1998) Housing investment: long-run international trends and volatility, Housing Studies, vol. 13 5. Bank for International Settlements (BIS) (2003) Real estate indicators and financial stability, BIS Papers No. 21. 6. Barkham R (2012), Real Estate and Globalisation, Wiley Blackwell. 7. Barkham R and Ward CWR (1999), Investor sentiment and noise traders, Journal of Real Estate Research, vol. 18(2), pages 291-312. 8. Barkham R (2001), “Office Market Analysis”, in Developers and Development, J Hennebury and N Guy (eds). 9. Barker K (2004), Review of housing supply, HM Treasury. 10. 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Muellbauer J and Murphy A (1997) ‘Booms and busts in the UK housing market’, Economic Journal, vol. 107, pp. 1701-27 19. Romer PM (1994). The origins of endogenous growth. Journal of Economic Perspectives, vol. 8(1), pp. 3-22. 20. Reichstein T, Salter A and Gann DM (2005). Last among equals: a comparison of innovation in construction, services and manufacturing in the UK, Construction Management and Economics, vol. 23(6), pp. 631-44. 21. Romer, P. M. (1994). The origins of endogenous growth. Journal of Economic Perspectives, vol. 8(1), 3-22. 22. Shiller R J (2008) The subprime solution: how today’s global financial crisis happened, and what to do about it, Princeton UP. 23. Shiller RJ (2003), From efficient markets theory to behavioral finance, Journal of Economic Perspectives, vol. 17(1): 83-104. 24. Summers LH, Minsky HP, Samuelson PA, Poole W and Volcker PA (1991), Macroeconomic Consequences of Financial Crises, in Feldstein M (ed), The Risk of Economic Crisis, http://www.nber.org/chapters/c6231.pdf Read More