The U.S. Housing Bubble & How it Led to the Great Recession

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(This article is under construction – come back soon!)

Introduction

Given that the gold standard was introduced as a commitment by those countries in participation to fix prices of domestic currencies in terms of gold in specified amounts, there are many reasons why this occurred and many sectors of the financial world which were adversely affected by the changes in recent decades. Currently, the gold standard has lost popularity and has been rejected by all governments, replaced completely by fiat currency. While seemingly unrelated and insignificant, the history of gold and the introduction of the Gold Standard played a large role in establishing an environment in which the housing market in the United States could expand and eventually burst as it did in 2000.

Pre-bubble boom

Focusing initially on floating currencies there are many costs and benefits which were seen as the dollar floated during the 1980’s as well as China’s fixed currency in 2009. It is important to understand the beginning decisions to back gold and the United States dollar backing the Euro as contributing factors to establishing the environment which the U.S. housing bubble was allowed to form and eventually burst. Reverting back to the 1980’s, many things went wrong with the Savings and Loan crisis in the United States, but what’s more important is how the “fix” actually worked. Why the Junk Bond King—Drexel Burnham Lambert and Mike Milken—worked, but then went wrong attributes to a better understanding of the fiscal dilemmas, but also, how the “fix” for this problem worked too.

Bubble mania

Long-Term Capital Management (LTCM) began and ended during the 1990’s. The company was a U.S. hedge fund which employed strategies which include pairs trading, statistical arbitrage. The company also used fixed income arbitrage. All three of these were united with high leverage. The Federal Reserve supervised the bailout of Long-Term Capital Management during the end of the 1990’s when the company was bailed by both banks and investment houses (Greenspan 2007, p. 193). In 1994, John Meriwether founded the company. Coming from a position as vice-chairman and head of bond trading, Meriwether once worked with Salmon Brothers. The board of directors was managed by Nobel Memorial Prize laureates, Myron Scholes and Robert C. Merton, in Economic Sciences. Long Term Capital Management was borrowing yen and gold (Greenspan, 1997). This is another example of a monetary policy which worked given the surrounding circumstances, then failed. This fiscal dilemma, however, presented consequences and lessons to be learned.

Following the historical decade wherein Long Term Capital Management was allowed to thrive and eventually die, Bill Clinton was elected into office and began to make many changes to the federal government and loan systems, all of which were done so under the auspices of helping the lower classes to afford new homes and bring them out of poverty. During the next decade, Bill Clinton relaxed the lending standards for Freddie and Fannie Mae to bad credit and public who were at risk. Many people who should not have otherwise qualified for loans especially loans at such high amounts, were given them nearly without question. People’s total debts were not considered, but rather, their income and presumed ability to repay their loans over time. Again, this is yet another dilemma which functioned temporarily under the current setting. The dawn of a new adventure began in 2000 when banks became sellers of product instead of lenders of money. This presented the beginning of a glorious new renaissance with new documented loans. It provided a $120 loan against someone’s house which created a job for mortgage dealers and brokers. This new period also brought with it liar loans and ninja loans.
Liar loans are a subsidiary of low-document loans and no-document mortgage loans. Liar loans were low-document loans abused so much by those in charge of the financial sector that they were nicknamed ‘liars’. Some liar loans required income as well as assets on the loan application, while others were dubbed no income, no asset loans. Loans of this type were typically abused by unethical borrowers and lenders who were able to overstate their income or their assets so as to receive larger mortgages than they would normally get. As part of the low-document loans, liar loans were programs meant for those with very low or poor income, or those who have sources of income which do not come from a monthly or bi-weekly stipend, such as entrepreneurs and those who receive tips. These loans are Alt-A lending types, meaning that they are dependent primarily upon a person’s credit score when determining their ability to repay a mortgage (Investopedia, 2012).

As these new loans were created and given to almost any person who applied, mortgage dealers were created after the creation of low-document loans as the broker and dealer who traded directly with the Federal Reserve System (Federal Reserve Bank of New York, 2010). The new roles of these dealers required making bids as well as making offers to the Federal Reserve System upon conduct of open market operations. They were also required to provide the open market trading desk with information, and they participated in U.S. Treasury securities auctions (Federal Reserve Bank of New York, 2010b). Consulting with the U.S. Treasury and the Federal Reserve System regarding the funds for the budget deficit as well as the implementation of monetary policy also fell under the job description of these new middlemen.

In addition to these new loan policies and middlemen, larger companies in the financial sector adversely affected the market and created the environment in which the U.S. housing bubble was cultivated. The role of S&P and Moodies encompassed 100% junk reclassified and sold 70$ AAA rated paper. The resale of sub-prime to unsuspecting banks and investors took place globally. During 2004 until 2007, the world experienced the Geanie Runs Rampage (Standard & Poor’s Financial Services, 2012).

Bubble Burst

In addition to ridiculous loan amounts and coverage, executive bonuses were given to CEO’s for no reason in filthy large amounts. Following this, CDs came onto the scene. By 2007, the music faded at the housing party and the plug was pulled on the party, showing the first signs of illness. This rolled into 2008 with the failure of Lehman Bros and Bear Stearns after over 100 years. AIG was amassing with debt, CDO’s, CDS, balance sheets, and sub-prime ownership, alongside Bank of America. In 2009, Barack Obama was welcomed into an office heavy with debt and no money. He created a stimulus plan immediately, the effects of which did not appear to simulate much. The U.S., at this point, found itself with twin deficits in both trade and budget. The U.S. dollar’s strength and labor competitiveness between U.S. automobiles, Chinese and Japanese automobiles proved worthless. Currently, the U.S. and Europe are in terrible shapes. The 1980’s bubble in Japan and burst and it seems no one has learned anything. The outlooks and conclusions we have may seem dim, but there is still light at the end of the tunnel.

Conclusion

In conclusion, beginning in the 1980’s, as Japan’s real estate and stock bubble was just shy of bursting, the U.S. began implementing a floating currency. As this continued, our market hit a pitfall in terms of the Savings and Loan crisis. Instead of learning from the giant bailout, American consumers and businesses began to take advantage of the recovery in the typical gluttonous fashion.  Companies like Drexel Burnham Lambert and Long Term Capital Management took advantage of the nation and the consumers. Trust was dispersed in an unattended fashion which inevitably led to providing means toward achieving the American dream which people could not afford. Consumers were urged to apply for credit no matter their financial history and Clinton urged credit suppliers to provide it. By 2000, the U.S. was known for no-and-low-document loans, mortgage dealers, astoundingly large executive bonuses, and sub-prime lending. Once the crisis hit, people began to realize how conservative they must be and should have been. The government has stepped in yet again to aid, with a stimulus plan that is slow to bring results and an economy which is not slow to recover. The dollar has once again lost its strength when compared to the European and Chinese currencies which are both shaping up to take the lead. The auto industry failed in its competitiveness as well as the labor industry. The only options left are to continue with operating recovery plans. While spending is not encouraged, it takes spending and investing with the dollar to stimulate the economy. As part of the reasoning behind Obama’s plans, this economy is being forced to spend in more monitored fashions and those who are in charge of financial institutions are being monitored to unprecedented ends.

References

Federal Reserve Bank of New York.(2010a). Primary Dealers. Retrieved 10th April, 2012,    from http://www.ny.frb.org/markets/primarydealers.html

Federal Reserve Bank of New York.(2010b). Administration of Relationships with Primary   Dealers. Retrieved 11th April , 2012, from         http://www.ny.frb.org/markets/pridealers_policies.html

Greenspan, A. (2007). The Age of Turbulence: Adventures in a New World. The Penguin     Press. pp. 193–195.

Greenspan, A.(1997). Government regulation and derivative contracts. Retrieved 10th April,           2012, from http://www.federalreserve.gov/boarddocs/speeches/1997/19970221.htm

Investopedia. (2012). Liar Loans. Retrieved on 10th April 2012, from               http://www.investopedia.com/terms/l/liar_loan.asp

Standard & Poor’s Financial Services. (2012). S&P – Indices > Equity Indices – S&P 500 –    Index Table. Retrieved 12th April 2012, from           http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_500/2,3,2,            2,0,0,0,0,0,0,0,0,0,0,0,0.html.


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