The US Housing Crisis, Economy and Stock Market

Hum Nath Panta

REAE 5311, Blog

Introduction

Current economic crisis in the United States of America is a by-product of sub-prime mortgage crisis in the US which has spread around the world. Sub-prime loan is a loan provided to borrowers who have low credit ratings and other factors that suggest a chance of defaulting on debt payment. Sub-prime loans have a higher interest rate than prime rate provided on traditional loans. Statistics shows that housing market started declining at the end of 2005. Simultaneously the Federal Reserve Bank started raising interest rate to tackle inflation at the end of 2005. This trend continued until the second quarter of 2007. Rising interest rates caused extremely difficult situation for existing as well as new home owners. As lending rates continued to rise, the cost of monthly mortgage payments rose significantly. As a result, many American homeowners were unable to pay for the homes they could never afford in the first place.

Raising interest rates not only created problems for existing home owners, but also had an effect in reducing the overall demand for new and existing houses. So, when mortgage became more expensive, only fewer Americans could afford houses. As a result, housing market started dropping thereby ending the housing market boom that lasted for a half decade. Moreover, when home owners realized that the home prices had started dropping and that could decline further, a number of home owners exit the market. Specifically, a large number of speculators exit the market at the first place. Then gradually, a large number of home owners could not keep their homes with lower market value compared to the mortgage value leading to excess supply of both existing and new homes and all this has caused significant drop in housing price and a record high foreclosure. As a result, US stock market in particular, and US economy as a whole, is suffering from bubble burst in the US housing market.

The Current Situation of Housing Market

It is very difficult to claim the exact date when the US housing market started declining. However, technical analysis of housing starts data shows that housing market started slowing during the first quarter of 2005. Housing starts dropped by 6.7 percent in March 2005 compared to the same period in 2004. Then we can observe short term jump until November 2005. By observing graphical presentation of housing starts and permits (see Figure 1), and housing starts percent change from a year ago (see Figure 2), we can clearly see that housing market started slowing at the end of 2005. Graphical presentation just gives an overview of downturn in the housing market but does not give a clear indication of actual housing bubble burst. Based on the previous statistics on housing starts change, we can define recession in housing market or housing bubble burst if housing starts change from a year ago is more than 10 percent persistently. For example, during 1974 housing crisis, August 1973 to June 1975 housing starts declined every single month by more than 10 percent from a year ago. Same pattern can be observed during 1991 recession when housing market was hard hit. Percent decline in housing starts from a year ago indicates that housing starts declined by over 10 percent every single month starting April 2006. Therefore, I want to test the hypothesis that housing market started declining from April 2006. To test this hypothesis, I created housing bubble dummy variable that takes value of 1 if observation occurs during the month of April 2006 to August 2008. Otherwise the housing bubble variable takes 0. I used seasonal dummy model with AR (2) process to test the hypothesis that housing market started slowing down from April 2006. Regression output shows that the housing bubble variable is negative and statistically significant at 1 percent significance level. (See regression output in Table 1).

Existing home sales statistics indicates that home sales rose 5.5 percent to seasonally adjusted annual rate of 5.18 millions units in September 2008 from the level of 4.9 million in August 2008. The existing home sales also increased by 1.4 percent in September 2008 from September 2007. However, price of existing homes is down 9 percent in September 2008 verses September 2007 (National Association of Realtors, 2008, also see Figure 3 and 4).Thus, housing market has not started stabilizing rather the downturn is continuous. The relentless downturn in home prices has left nearly one in six US homeowners owing more than the home is worth, raising the possibility of a rise in defaults. The more home prices drop, the more people feel less rich and thus people decrease their spending on goods and services. In addition, the result of home owners being underwater creates more pressure on already sluggish economy. Moreover, having more homeowners under water is likely to mean more eventual foreclosure since it is hard for borrowers in financial trouble to finance or sell their homes and pay off their mortgage if their debt exceeds their home value. Foreclosed homes also tend to lower the value of other homes in neighborhood (Hagerty and Simon, Wall Street Journal, October, 2008). According to the Mortgage Bankers Association in Washington, U.S. foreclosures rose at the fastest rate in almost three decades, to a record 2.75 percent of all mortgages, in the second quarter of 2008. According to RealtyTrac Foreclosure report released in September, 2008, home foreclosures rose 26.7 percent in August from a year earlier. An estimated one in every 416 homes is in some stage of foreclosure (Homan, 2008). Thus housing crisis is an ongoing vicious circle, is affecting every sector of on the US economy.

Housing Market and the US Economy

Real estate market is one of the very important contributors to the US economy. It generates over 28 percent of the US gross domestic product (GDP), creates about 9 million jobs, and generates nearly 70 percent local government revenues (Ling and Archer, 2008). Moreover, real estate market constitutes the single largest asset class in the US. The estimated total market value of real estate is approximately 23.4 trillion which includes owner-occupied housing, investable commercial real estate, and land excluding non real estate corporation and real estate owned by governmental agencies (Ling and Archer, 2008). These statistics indicate the importance of real estate in the US economy.

Real estate market has a very significant contribution to the US GDP through construction spending. According to contribution of office, in 2005 $1.14 trillion in construction spending contributed $3.9 trillion to US GDP. Of the $1.14 trillion, an estimated $148 billion was spent on construction of non-governmental offices, industrial warehouses and retail buildings. Therefore, each dollar in new construction spending increases GDP by $3.42. Detailed information about construction spending is presented in Figure 5. Therefore, real estate market has a very important contribution to the US economy.

Almost every financial institution is venerable due to sub-prime mortgage crisis. Financial institutions have written off billions of dollars bad debt. So the current credit market situation is really tight. Tight credit markets have further exasperated economic downturn. In this situation, as companies find it harder to secure financing, business spending is likely to be constrained and this is more likely to cause more layoffs in near future. According to Bureau of Statistics, the unemployment rate increased to 6.1% in September 2008, up from less than 4.5% in January, 2008. The unemployment rate is expected to increase in the next 12 months. According to US Census Bureau, new orders for manufactured goods in August 2008 decreased by $18.6 billion or 4.0 percent to$444.4 billion (See Figure 6). Thus, the overall prospect of the US economy is suffering mainly due to housing crisis.

Housing Crisis and Financial Institutions

There is no doubt that housing crisis has hit harder to homeowners. Thousands of homeowners are forced to walk away from their homes mainly for two reasons. First, it is very hard to get affordable refinancing. Second, the sharp decline of home prices has made homeowners more inclined to default their loans as the home value is far less than the mortgage balance. In other words, loan to value ratio has increased very significantly, which creates incentive for homeowners to walk away form their homes.

Financial institutions, banks, insurance companies, hedge funds and individual investors who have a significant portion of mortgage-backed securities are hit even harder from the free fall of housing prices. According to Richard J. Fox, majority of mortgage-backed securities received an “AAA” rating by various rating agencies. This triple A ratings enabled financial institutions to sell their mortgage-backed securities to countless banks, insurance companies, hedge funds, individual investors. These investors believed that they would be able to earn higher rate of return from the mortgage-backed securities compared to other financial instruments with the same ratings until the housing bubble burst started showing its real effect last year.

Now the financial industry is facing a great challenge in history. This crisis has caused a severe blow to the world economy. The current crisis is even more severe than any other crisis after the world depression of 1929 in the sense that the whole credit market around the world is frozen. Some banks and insurance companies have already bankrupted. Without government intervention, several banks and institutions would fail. Still nobody knows how many banks, financial institutions, insurance companies will fail in the near future. So this credit crunch caused by the housing bubble burst has severely damaged the world economy.

Financial institutions and banks are heart of economy. Sound financial system and people’s trust towards the system are crucial to the economic prosperity. They are missing in current world economy. For the first time Bear Stearns, a New York based investment bank collapsed there by being the first victim of the sub-prime mortgage crisis in the US. Then it was followed by IndyMac Bank. The US government is doing all it can do to protect the financial system. However, banks and financial institutions are crumbling. Another blow to the US credit market is failure of investment bank Lehman bothers followed by the failure of Washington Mutual and Wachovia bank. Without the government intervention, nations’ largest insurance giant American International Group, Inc (AIG), mortgage giants Freddie Mac and Fannie Mae would have clasped. It would have devastating effect on the US financial and stock market. For the first time Japan's Yamato Life Insurance filed for bankruptcy in October 10, 2008 with USD 2.7 billion in liabilities, to become the first financial sector casualty of US credit crisis in Japan. Thus, the housing bubble has crippled not only the US economy but also has spread rapidly throughout the world.

Housing Crisis and Stock Market

Over the past three years, construction spending has been decreasing continuously. According to U.S Census Bureau, total construction in July 2008 has decreased by 4.8 percent compared to July 2007. Residential construction spending has decreased by 27.1 percent in July 2008 form the same period last year. So, the total private construction decreased by 9.2 percent in July 2008 compared to the same period in 2007. This means the economy lost $78,264 millions total private construction spending in July 2008 compared to the same period in 2007. This figure is equivalent to $276,663 millions loss in the US GDP in 2008. Therefore, the housing crisis has caused significant damage to the US economy.

Sound economy is the heart of stock market. The housing crisis has severely affected the US economy. Consequently, currently stock market is facing a great challenge. This effect comes from economic downturn and the destruction of financial system. As of October 8, 2008 Dow Jones Industrial Average, S&P 500 and NASDAQ have lost all 5 years of gain. In other words, 5 year returns of Dow Jones Industrial Average, S&P 500 and NASDAQ are negative 3.87, 4.72 and 8.10 percent respectively (See Figure 7). Millions of American people have lost more than two third of their retirement investment value. In fact, the world economy is facing the greatest crisis since the great depression of 1929. Investors have lost confidence in the market. Market is melting down each and every day. Technical indicators indicate that the economies around the globe are on the verge of sliding down to deep recession led by the US financial crisis. According to economist.com, the financial crisis has broadened and intensified, the global economy has begun to suffocate, and global recession is almost certainly underway. Current credit crunch is a pure by-product of sub-prime mortgage crisis. Thus, housing crisis has caused a significant damage to the world economy in general and stock market in particular.

What can be done?

Housing crisis is the heart of current crisis. However, the current crisis has spread beyond the housing sector. I believe that stabilization of housing prices is necessary to the economy at large. Therefore, it is necessary to adopt measures to stabilize or stop the decline of housing prices to stop and repair the current failing financial system. Once the economy realizes stabilization in housing prices, it will immediately result multiplier effects. Housing recovery will stop further foreclosures and loan defaults in the first place. Moreover, it is necessary to make sure that credit is available in the market so that market starts functioning naturally. Such measures gradually normalize economic activities.

To stabilize housing prices and credit market, government and responsible authorities should regulate housing and credit market effectively. Government should freeze or lower monthly mortgage payment for those home owners unable to afford monthly payments for at least some times. Government also has to make sure that affordable credit is available to new entrants in the housing market. Housing market and financial institutions should be strictly regulated to prevent repetition of the crisis in financial and housing industry in distant future. If necessary, government should also provide insurance for new mortgage to guarantee banks investment on such loans to normalize credit market. Primarily in open market economy, market itself corrects if any anomalies and disparities appear. However, government intervention is necessary to increase confidence in housing and credit market which is the heart of the current crisis in stock market.

Conclusion

Economies around the world have been suffering from cyclical effects from time to time. The current US housing crisis is one example of cyclical effects. The US economy suffered from housing slump in 1974. However, the current housing crisis is completely different from the previous housing slump since many players such as banks, financial institutions, insurance companies, hedge funds, and individual investors are directly involved in this crisis. The current housing crisis is not only the meltdown of real estate market but has stained the whole financial system. Governments around the globe are doing their best they can do to prevent further deterioration in the credit market, however these measures have not been effective. I think no government intervention can cure this crisis right away. Government intervention needs some time to have effects. Market is more about psychology. Therefore, any measures adopted by government should be directed towards restoring the trust in financial system and reduction of psychological fear in the market.

Reference

Hagerty and Simon (2008), The Financial Crisis: Housing Pain Gauge: Nearly 1 in 6 Owners 'Under Water' - More Defaults and Foreclosures Are Likely as Borrowers With Greater Debt Than Value in Their Homes Are Put in a Tight Spot, Wall Street Journal, October 8, 2008.

Ling, D. C. and Wayne R. Archer (2008), Real Estate Principles: A Value Approach, 2nd edition, McGraw-Hill/Irwin, Inc. 2008

NAIOP Research Foundation, < http://www.naiop.org/foundation/home.cfm

http://www.realtor.org/press_room/news_releases/2008/ehs_rise_on_affordability, http://www.naiop.org/foundation/contdev.pdf >

National Association of Realtors, 2008, <http://www.realtor.org/research.nsf/pages/EHSdata >

Phil Izzo, Economists Expect U.S. Crisis to Deepen, October 1, 2008

<http://finance.yahoo.com/banking-budgeting/article/105935/Economists-Expect-U.S.-Crisis-to-Deepen>

Timothy R Homan (2008), U.S. Pending Home Re-sales Rise 7.4% as Prices Drop, October 8, 2008. <http://www.bloomberg.com/apps/news?pid=20601087&sid=avsj6v77XbhI&refer=home>

The Economists <http://www.economist.com/finance/displayStory.cfm?story_id=12382253&source=features_box_main&ref=patrick.net >

U.S Census Bureau, Press Release, August 2008, <http://www.census.gov/const/www/prpage.html>

U.S.News and World Report, Retirement Savers Lost $2 Trillion

<http://biz.yahoo.com/usnews/081008/08_retirement_savers_lost_2_trillion_in_the_stock_market.html?.&.pf=retirement >.