Housing Bubble Research Paper

The Housing Bubble: America’s Downfall
Linda Smith
Professor Bolden

Abstract

A housing bubble is a situation where there is an extremely high demand for housing, but this demand is created through artificial ways, like lowering interest rates. The interest rates are lowered to create a false sense of security for consumers and can lead to economic boom. Also, as we are learning the hard way in the United States, it can end in economic hardships.

Most Americans would tend to agree that the housing bubble has affected all of us in some way or another. Whether we lost a house, a job, or a business it affect us. The housing bubble gave most Americans a false sense of security to spend money that they really didn’t have. Americans that
could not afford homes in past were acquiring loans with creative lending practices that led them to later on lose their American dream or struggle to keep it.

According to (Black, K., n.d.), one of the main reasons a housing bubble is created is due to a desire by a national bank, such as the Federal Reserve in the United States, to lower interest rates to spur the economy. This creates an interest by some to purchase real estate because it becomes cheaper to acquire that real estate. Therefore, demand goes up. Added to this is the practice of house flipping, in which a home is bought for short-term gain, and the market is further inflated by an artificial demand. As demand increases, prices increase -- substantially more, in some cases, than what may be considered the fair market value.

A housing bubble creates a beneficial financial situation for other businesses as well. Construction companies, plumbing companies, electrical companies, engineering companies, and home builders were so busy with work that they had to hire many employees to keep up with the boom. This housing bubble created a circular glow of production and income for our economy. The problem is that this beneficial situation is short lived. “According to (Black, K., n.d.), the end of the housing bubble usually happens when interest rates are raised, which must happen if any country is to operate without crippling inflation.” Financial specialists refer to low interest rates as "cheap money." When the interest rates rise, money is more expensive to borrow.

From the mid 90 's to the early 2000 's, the amount of subprime mortgage loans rose significantly. In order to stay competitive, lenders had to broaden their range of mortgage products and start offering loans to borrowers that would normally be turned down for financing. This practice became known as subprime lending. Some lenders decided to specialize in this type of untraditional lending. The subprime loans that were offered to borrowers has a much higher interest rate and in turn proved to be very profitable for the lenders.

At an annual housing policy meeting in 2004, Governor Edward Gramlich (who was a member of the Board of Governors of the Federal Reserve at that time) had the following remarks about the two sides to subprime mortgage lending.
(Cornett, B. 2007)
On the down side of subprime lending:
While the basic developments in the subprime mortgage market seem positive, the relatively high delinquency rates in the subprime market do raise issues. ... For mortgage lenders the real challenge is to figure out how far to go. ... If lenders do make new loans, can conditions be designed to prevent new delinquencies and foreclosures?" (Cornett, B., 2007)
On the up side of subprime lending:
The obvious advantage of the expansion of subprime mortgage credit is the rise in credit opportunities and homeownership. Because of innovations in the prime and subprime mortgage market, nearly 9 million new homeowners are now able to live in their own homes, improve their neighborhoods, and use their homes to build wealth."(Cornett, B.,
2007)

The up side and down side of subprime lending leads one to ask the question: “Is subprime lending ethical?
Is making money off of borrowers who really can’t afford a house and charging them higher interest rates to borrow the money a well designed plan?” It seems as if these subprime borrowers were used to boost the economy at one point but when the housing bubble burst who helped them keep their homes and their American dream?

“Between 2000 and 2006, the number of home foreclosures continued to rise in America. A barrage of studies and data analysis suggested a strong connection between the rise in foreclosures and the subprime mortgage lending market.” (Cornett, B.,
2007)

Randall Kroszner, the current Federal Reserve Board Governor, had this to say on the connection between subprime lending, foreclosures, and ARM loans:
This guidance ... underscores that the Federal Reserve and other banking regulators expect lenders to make sure subprime borrowers not only can afford their monthly payments while the introductory rate is in effect but also after the interest rate resets." (Cornett, B., 2007) The mortgage crisis has a serious effect on the economy. There have been many home foreclosures and lenders were forced to change their lending policies. But who can we blame for the current condition of the economy? “Whenever a financial crisis emerges in this country, the blame game starts immediately. So whose fault is all this? Who is to blame for the mortgage crisis that has essentially wrecked our economy? Well, we are all to blame, in one way or another. The greedy lenders are the easiest targets. The politicians who ignored warnings are second in line. And let 's not forget all of those consumers who didn 't read the fine print.” (Cornett, B., 2007)

References
Black, Ken (2003-2009). What is a housing bubble? http://www.wisegeek.com/what-is-a-housing-bubble.htm, retrieved 11/29/09
Cornett, Brandon(12/18/07). Subprime mortgage crisis explained. http://www.homebuyinginstitute.com/homebuyingtips/2007/12/subprime-mortgage-crisis-explained.html, retrieved 11/29/09