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Since the 1950s, Americans proved to be innovators of spending money. Bursting of the housing market bubble, subprime loan fiasco, wars contributed to credit crunch. This paper examines possible implications for consumers, financial institutions, housing market. It concludes that the correct approach must allow the marketplace to operate independently.
Since the 1950s, Americans proved to be innovators of spending money. Bursting of the housing market bubble, subprime loan fiasco, wars contributed to credit crunch. This paper examines possible implications for consumers, financial institutions, housing market. It concludes that the correct approach must allow the marketplace to operate independently.
Since the 1950s, Americans proved to be innovators of spending money. Bursting of the housing market bubble, subprime loan fiasco, wars contributed to credit crunch. This paper examines possible implications for consumers, financial institutions, housing market. It concludes that the correct approach must allow the marketplace to operate independently.
ECONOMY AND GLOBAL MARKETS: HOW DAMAGING WILL IT BE?
Ashley, Clyde Ph.D. Florida A & M University Clyde.ashley@famu.edu
Krystal D. Wilson Florida A & M University darcell2005@yahoo.com
ABSTRACT Since the 1950s, Americans proved to be innovators of spending money. Heading into the 1980s, they invested their savings into the booming stock market and used their earnings made from the stock market to spend in excess of their normal income. Since then, it became a growing commonality for Americans to borrow against their home values. The bursting of the housing market bubble, subprime loan fiasco, costly wars in Iraq and Afghanistan, excessive tax breaks, and the $9 trillion federal debt all contributed to the U.S. credit crunch and the impending economic recession.
This paper examines the credit crunch issue and analyzes possible implications for consumers, financial institutions, housing market, student loans, U.S. economy, and global financial markets. Numerous proposals and plans have been offered by Congress, the current Administration, Senator Obama, Senator McCain, and the Federal Reserve.
Addressing the credit crunch issue in an effective way will require a comprehensive and wide ranging strategy. The credit crunch problem impacts several industries (housing, banking, investment, automobile, student loans) and governmental operations. This paper concludes that the correct approach must allow the marketplace to operate independently, along with the careful use of monetary and fiscal policy. There is a need for the government to monitor and provide oversight to make sure that market forces are fair and efficient.
INTRODUCTION For more than half a century, Americans have been ingenious at finding new ways to spend money. The 1950s and 1960s manifested the rising popularity of credit cards. It marked the growing commonality to buy now and pay later. Instead of waiting for payday, many Americans began using the available credit from credit cards to fulfill wish lists and to cover miscellaneous expenses. Leading into the 1980s, millions of Americans entrusted their savings to the thriving stock market, and used their winnings to spend in excess of their income. Recently, millions more borrowed against the value of their homes. However, the United States recent economic downturn suggests that the glory days of credit and risk are over (at least for some period of time).
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Proceedings of ASBBS Volume 16 Number 1 Currently, the United States is in the midst of a credit crisis and/or credit crunch. Credit crunches are considered to be an extension of recessions. A credit crunch makes it nearly impossible for companies to borrow, because lenders are afraid of bankruptcies and defaults that result in higher interest rates. The consequence is a prolonged recession (or slower recovery) and it occurs as a result of the shrinking credit supply.
The unraveling of the real-estate market appears to have left millions of American families with limited choices and unable to take of advantage of new credit opportunities. The construction of this research paper supports historical, present, and future analyses; proposed solutions; and a thorough identification of the impact that the credit crunch has on the United States economy and global markets.
ANALYSES The models below differentiate subprime lending and traditional lending. Traditional functions of mortgage lending position banks to finance mortgage lending with deposits received from customers. Subprime lending allows banks to sell mortgages to bond markets and creates a new way to fund additional borrowing. It leads to banks losing the incentive to carefully monitor the mortgages they issue (see Figure below).
The subprime mortgage market lends money to people who dont meet the credit or documentation standards for ordinary mortgages. These borrowers are individuals with poor credit histories and weak documentation of income, who were rejected by the "prime lenders such as Freddie Mac and Fannie Mae. Subprime lending proved to be extremely profitable for banks. They earned a fee for each mortgage sold and urged mortgage brokers to sell more and more of these mortgages. Currently, the mortgage bond ASBBS Annual Conference: Las Vegas February 2009
Proceedings of ASBBS Volume 16 Number 1 market is worth $6 trillion and is the largest single part of the whole $27 trillion US bond market, bigger than Treasury bonds.
Banks and lenders believed that the risks of subprime loans could be managed, a belief that was fed by constantly rising home prices and the perceived stability of mortgage-backed securities. However, while this logic may have held for a brief period, the gradual decline of home prices in 2006 led to the possibility of serious losses. As home values declined, many borrowers realized that the value of their homes exceeded the amount they owed on their mortgages. These borrowers began to default on their loans, which drove home prices down further and ruined the value of mortgage-backed securities (because the underlying assets behind the securities were now worth less). This downward cycle helped to create a mortgage market meltdown.
The practice of subprime lending has widespread ramifications for many companies, with direct impact on lenders, financial institutions, and home-builders. In the U.S. housing market, property values have plummeted as the market is flooded with homes, but lacking buyers. The crisis has had a major impact on the economy at large. Rather than lending money for business growth and consumer spending, it forced lenders to hoard cash or invest in stable assets. This contributed to a number of factors that led to the credit crunch that occurred in 2007.
For the first time in decades, credit is extremely tight as the bursting of the housing bubble has spread misery over Americas financial system. During the Summer of 2007, these new vulnerabilities of our financial system became evident. Looser credit standards in the housing market, combined with an end to rapid home-price appreciation, led to a significant rise in delinquent mortgages. In turn, this has contributed to immediate and unexpected losses for investors and a reconsideration of the risk-reward relationship, first in housing and then in all asset classes. It drove up demand for cash and liquidity and restrained the pace of new lending and investment, which is necessary for strong growth to continue. Investors shaken confidence in the housing market could possibly impact global markets, both short-term and long-term.
For many years, Cleveland, Ohio was the sub-prime capital of America. Mortgage brokers focused their efforts by selling sub-prime mortgages in working class black areas, where many people had achieved home ownership. They were offered cash by refinancing their homes, but brokers often neglected to properly explain that the new sub-prime mortgages would "reset" after 2 years at double the interest rate. The result was a wave of repossessions that blighted neighborhoods across the city and the inner suburbs. By late 2007, one in ten homes in Cleveland had been repossessed and Deutsche Bank Trust, acting on behalf of bondholders, was the largest property owner in the city.
In 2005, sub-prime lending had spread from inner-city areas across America. During that year, one in five mortgages were sub-prime and they were particularly popular among recent immigrants trying to buy homes for the first time in the "hot" housing markets of Southern California, Arizona, Nevada, the suburbs of Washington, DC, and New York City. These mortgages had a much higher rate of repossession than conventional mortgages, because they were adjustable rate mortgages (ARMS). The payments were fixed for two years, and then became both higher and dependent on the level of Feds interest rates, which also rose substantially (see Figure below).
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Consequently, a wave of repossessions is sweeping America, as many of these mortgages reset to higher rates over a two year period. It is likely that as many as two million families will be evicted from their homes, as their cases make their way through the courts. The Bush Administration is pushing the industry to renegotiate, rather than repossess where possible. Mortgage companies are being overwhelmed by a tidal wave of cases.
The wave of repossessions is having a dramatic effect on housing prices, reversing the housing boom of the last few years and causing the first national decline in housing prices since the 1930s. There is a glut of four million unsold homes, which is depressing housing prices. Builders have also been forced to lower prices to get rid of unsold properties. Housing prices are declining at an annual rate of 4.5% and are expected to decline at least 10% by next year and even more so in areas such as California and Florida (see Figure below).
The housing market crash is also affecting the broader economy. The building industry is expected to cut its output by half and cause a loss of one to two million jobs. Many smaller builders will go out of ASBBS Annual Conference: Las Vegas February 2009
Proceedings of ASBBS Volume 16 Number 1 business and larger firms are also suffering huge losses. The building industry makes up 15% of the US economy, but a slowdown in the property market also hits many other industries. No one is sure how long the slowdown will last. Many U.S. consumers have spent beyond their current income by borrowing on credit and the fall in the value of their homes may make them reluctant to continue this pattern in the future. One reason the economic slowdown could get worse is that banks and other lenders are cutting back on how much credit they will make available. They are rejecting more people who apply for credit cards, insisting on bigger deposits for home purchases, and looking more closely at applications for personal loans. In the U.S., many undergraduates take out federal guaranteed loans and cover their financial needs with private loans from lenders, such as Bank of America, JP Morgan Chase and Citi-Group. During the academic year 2005-2006, $17 billion in private student loans was used to finance higher education.
Banks have become reluctant to offer private student loans, because worsening credit conditions have meant that they cannot package up the loans and sell them. Joe Belew, President of the Consumer Bankers Association, said: Some of the banks are getting out. Part of the reason is that Congress has cut the fees they could charge, making some loans pretty much unprofitable. Another reason is that they cant securitize the debt.
The problems they have had with mortgage-backed debt are some of the same in student lending. We have talked to some of the banks about this. Its a painful decision to pull out, because of the nature of the clientele, everyone wants to be in the business of helping people get ahead, but at the end of the day you still have to deliver value to shareholders. At the moment, its a fine line between hanging in there and pulling out. Its a murky situation.
In March of that year, Iowa Student Loans said that it would soon stop offering private loans altogether. The group, which made 29,000 student loans the previous year, said: This is really a reaction to the economys recent situation, the sub-prime market in particular.
Several members of Congress have urged the Bush Administration to stabilize the market after the National Association of Independent Colleges and Universities gave warning that student loans have become far harder and costlier to obtain, since the credit crisis. In October 2007, as the credit crisis on Wall Street was gathering pace, Congress introduced legislation limiting the returns that banks could extract from student loans.
Anyone shopping for a home will feel the immediate impact of the new attitude among lenders, with no documentation (no-doc) and low documentation (low-doc) mortgages becoming a thing of the past. Lenders are demanding more traditional 10% to 30% down payments. It sounds extreme, but maybe not, considering that mortgage giants Fannie Mae and Freddie Mac are hiking fees sharply for borrowers with less-than-stellar credit scores, who put down less than 30% for a home.
Also suffering huge losses are the bondholders, such as pension funds, who bought sub-prime mortgage bonds. These have fallen sharply in value in the last few months, and are now worth between 20% and 40% of their original value for most asset classes, including those considered safe by the ratings agencies. If the banks are forced to reveal their losses based on current prices, they will be even bigger. It is estimated that ultimately losses suffered by financial institutions could be between $220 billion and $450 billion, as the $1 trillion in sub-prime mortgage bonds is revalued.
The American people seem to be taking the burden of a weakening economy, a drastic credit crunch, and a faulting housing market in stride. However, the overall impact on the U.S. economy and the global ASBBS Annual Conference: Las Vegas February 2009
Proceedings of ASBBS Volume 16 Number 1 markets are yet to be determined. Economies worldwide are reporting losses caused by the drop in the U.S. dollar. Consumers and lenders are well aware of their own financial difficulties. Yet, as credit rates rise and with foreclosures becoming an all too common event, changes in the US economy having a spillover effect on global markets.
The International Monetary Fund (IMF) released numbers estimating the world wide effect of the credit crunch. The estimates show a $945 billion dollar loss on a global scale over the next two years. The IMF predicts that the worst is not over just yet and that consumers and investors should prepare for a continual weakening of the economy. Also, the IMF estimated that the housing market alone can see losses as high as $565 billion. The IMF expects to see additional losses in other areas of the economy, which do not necessarily have anything to do with the housing market. Loans that are tied in with credit cards can be expected to see additional losses, along with the commercial real estate sector.
Two-thirds of domestic banks tightened lending terms between April and July 2008, for credit cards and other consumer loans. That was up from roughly a third of banks tightening credit-card loans in the prior three-month period, and almost half of banks tightening standards for other loans. Banks also are increasingly raising minimum credit scores for consumer loans and lowering credit limits on credit-card accounts. The stricter terms in the sector could threaten consumer spending, which accounts for more than 70% of U.S. economic activity, into next year. A weak labor market, high energy prices and the fading effect of government stimulus checks are already poised to restrain consumers in the coming months.
The Fed survey, conducted in July and released in early August, found 60% of domestic banks expected to tighten standards on credit-card loans in the second half of the year, and more than a third expected to tighten those standards in the first half of next year. While the latest tightening was sharpest in credit-card and other consumer loans, it also showed more banks growing restrictive in their lending for mortgages and business loans. Banks had already significantly tightened terms for those loans. The credit tightening is likely to hit the battered housing sector further, weighing on home sales and prices. About three out of four banks -- up from 60% in April -- said they tightened lending standards for prime mortgages. Almost half said they would tighten further in the second half of this year, and a third said they would tighten standards in the first half of 2009. About 85% of banks that originated nontraditional residential mortgage loans tightened standards on those loans. Two-thirds of banks originating nonprime loans expected to tighten further in the second half of this year (see Figure below). ASBBS Annual Conference: Las Vegas February 2009
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About 60% of banks reported stricter lending standards for medium and large size firms in the prior three months. Roughly two-thirds of these firms said they were doing the same for small businesses as well, up from about half in the April 2008 survey. Four out of five banks -- increasing 10% since April -- said they increased the spreads between the loan rates and their cost of funds for large and middle-market firms, while a slightly smaller fraction did so for smaller firms. More than half of domestic banks said they expected to tighten lending standards to businesses in the second half of this year, and a little less than half said they would do so in the first half of 2009. The moves could restrain business investment even further in the coming months.
RECOMMENDED SOLUTIONS Since the start of the mortgage meltdown, political heads and financial advisors have proposed many solutions. These efforts are designed to address the instability of the financial market and to spur growth in the U.S. economy. At the close of July, landmark housing legislation cleared Congress, allowing the U.S. Treasury to gain unprecedented power over the next 17 months. The Treasury purchased majority equity interest in mortgage giants Fannie Mae and Freddie Mac. The Federal Housing Administration (FHA) was granted $300 billion in new loan guarantee authority. It was designed to help establish a new limit for home prices and be a source of refinancing for households at risk of foreclosures.
Additionally, $15 billion in new housing-related tax breaks and almost $4 billion in aid was authorized to help urban communities. These communities are often stressed by concentrated foreclosures in individual neighborhoods. In the case of FHA, the bill has the potential to help as many as 400,000 at-risk homeowners, but lenders must first agree to take losses on the loan principal before FHA can provide refinancing. Only primary residences would be covered and homeowners must share any profit from the sale of the refinanced home. Higher fees would be charged to establish a reserve fund to protect the taxpayers in case of default.
Back in December 2007 presidential candidate Senator Barack Obama proposed tax breaks to help millions of homeowners make their payments. This proposal was designed to provide direct relief for the victims of mortgage fraud and counseling so homeowners could avoid foreclosure and opt to refinance. He outlined a program to help make it easier for middle-class families, not speculators, to renegotiate or refinance their mortgages.
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Presidential candidate Senator John McCain has rejected this aggressive government intervention in the economic meltdown. He believes that there should be limited government assistance to the banking system to prevent systematic risk that might endanger the entire financial system and the economy.
The credit crunch is a major issue confronting the American economy and global markets. Finding solutions to such a major problem will require a comprehensive approach. These will include increased roles for the Federal Reserve, Securities and Exchange Commission, the U.S. Treasury, Presidents Administration, and Congress (House and Senate). To address the credit crunch problem, it would be necessary to employ sound monetary and fiscal policy with monitoring and governmental oversight. For instance, the last two investment banks left standing, Goldman Sachs and Morgan Stanley will now become commercial banks, abandoning the investment-banking model that provided huge profits in recent years but also brought the firms to the edge of oblivion. The legal shift puts the finishing touch on the most powerful wave of change Wall Street has seen since the Great Depression.
Yet, there is no simple or one-size-fits-all solution. The goal should be to adopt a feasible plan of action that will address the problem both short-term and long-term.
CONCLUSION The U.S. credit crunch has negatively impacted the U.S. economy, U.S. financial market, and global financial markets. If this issue is not immediately confronted, the short-term and long-term outlook will be catastrophic. There is an urgent need to restore confidence of investors, consumers, the financial community, and global markets.
This paper concludes that the severity of the U.S. credit crunch requires a comprehensive plan that will reverse the current trend of skeptical lending practices. To spur the economy, lending institutions must make funds available so businesses and consumers can increase their level of spending.
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Lerer, Lisa (2008). "McCain guru linked to subprime crisis." Politico, Mar 28. http://www.politico.com/news/stories/0308/9246.html
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