• Ganesh

The housing bubble: 2008 financial crisis!

The financial crisis of 2008 aka great recession had a devastating effect on economies all over the globe. It is important to know about it as there is a saying "History tends to repeat itself"

The Bubble

An economic bubble is formed when more people buy an asset with the hope of making profits based on the speculation and hype created. It escalates the asset price than the actual value. This creates FOMO among others more people tend to buy it and finally bubble deflates as massive sell-off takes place when people realize that the asset isn't worth it(i.e, overvalued).

It all started way back when people had easy access to credit.

  • Banks were lending money for low-interest rates(In 2003 federal funds rate was 1%), had relaxed lending standards, and low down payment requirements.

  • subprime mortgage allowed low credit score borrowers (they are those who are most likely to default on loans) to buy loans. Real estate was considered a good investment and by 2004, housing prices were skyrocketing.

Many people borrowed the loans(which they will default on) and invested it in real- estate by assuming that they'll repay it using the gains. The demand for property escalated, so did the price of assets and the number of people borrowing the loans so, Between 1998 and 2006, the price of the typical American house increased by 124%

Secondary Mortgage Market

Banks sell Collateralized Debt Obligation(CDO) to the investors. CDO is nothing but the financial product which is made up of packages of mortgage papers and other loans of borrowers. Since the bank sold the mortgage, it can make new loans with the money it received. It may still collect payments form borrowers, but it sends it to the investor. Mortgage papers are rated as low and high risk by credit rating agencies. Banks sold more high-risk (CDO)(it contained mortgage papers of people who are most likely to default on loans as banks made loans to borrowers who weren't credit-worthy. and hence it is high-risk CDO) to investors because of the demand among them. As banks make more loans, the investors were buying more such securities.

What led to the bubble burst

  • Housing prices peaked in early 2006, started to decline in 2006 and 2007, this created a panic and massive sell-off took place. Home price declined drastically forcing borrowers to sell at loss.

  • Mortgage debt was higher than the value of the property i.e, mortgage holders owe more on their loans than the worth of their home.

  • Investors started losing money on their investments in mortgage-backed securities(kind of COD but only contains packages of mortgage loans) as browsers defaulting

  • The secondary mortgage market had trouble when investors stopped buying MBS as they were no longer valuable

Effects and aftermath

The housing market had devastating effects, many ended up losing their homes.

and the prices of homes fell. Investors lost a huge sum of money and investment bank like Lehman Brothers filed for bankruptcy, This caused a crisis on Wall Street and resulted in plummeting stock market prices in the United States and around the world.

the financial crisis created a downturn in economic activity which led to recession and millions lost their jobs, average salaries and net worth of typical households decreased.

The Federal Reserve reduced the federal funds rate to boost economic activity and the Fed initiated the first in a series of large-scale asset purchase (LSAP) programs, buying mortgage-backed securities and longer-term Treasury securities. These purchases were intended to put downward pressure on long-term interest rates and improve financial conditions more broadly, thereby supporting economic activity. The fed also uses other policies to promote economic activity.

The fed increase and decrease the interest to influence the cash flow in the economy

when the fed increase the internet rate, credit is not easily accessible and there will be fewer borrowers of loan from the banks and hence less economic activity takes place, less economic activity for a longer period of time will lead the economy to deflation as one man's spending is other man's income (overall spending reduces so price of goods and commodities reduces) and finally to rescission.

When fed decreases the interest rate, credit becomes easily accessible and there will be more borrowers of the loan and more economic activity takes place and people spend more on goods and commodities and prices increase and it might lead to inflation.

when you compare interest rate and s&p 500 index there is a boom when fed decrease interest rates

(there was dot-com bubble burst in the 2000s).

Many such economic might bubble might be formed in the future and it is essential to protect your investments.

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