Trend in Housing Prices (2005)
1.1 Introduction
In the last three years, the United Stated witnessed what is referred to in economic terms as the sub-prime mortgage crises. A subprime mortgage is granted to borrowers whose credit history is not sufficient to get a conventional mortgage. Often these borrowers have impaired or even no credit history. Subprime mortgages often offer interest-only loans. Thats because an interest-only loan is easier to afford. The loan doesnt require that any of the principle be paid for the first several years of the loan.( UseEconomy 2009). In 2005 home prices in the USA where at record highs as can clearly be seen in the diagram below (Fig 1).
Demand for new homes was high as regulations which regulated the taking of loans to finance mortgages were stringently. The result was a boom in the housing market and prices. This bubble finally burst in 2008 with devastating consequences for the US economy and the whole world.
The United States housing market is an integral part of the United States economy. Its influence stretches out to many sectors of the economy thus anything that happens in the housing industry has a knock on effect on the whole economy. According to an online investor dictionary, the term housing market relates to, General market of houses being purchased and sold between buyers and sellers either directly by owners or indirectly through brokers. While there is no physical exchange for a housing market, the general term often refers to the performance of the Housing Market Index but not the Housing Market Index itself. In essence the housing market functions like any other free-market mechanism whereby the forces of demand and supply are at play and help to determine the prices of homes.
This paper seeks to analyze the prices of houses in the last three year and try to determine what path this market is going to take in the next three years. The sub-prime mortgage crises will feature prominently in this paper as we analyze what has taken place in the US housing market especially within the last three years. Government Intervention and the behavior of some financial institutions will be looked at to see how they have all had an effect on home price trends nationwide.
1.1 How the housing market functions
Home prices are determined by the forces of supply and demand. Below is an illustration of how this simple mechanism works
An increase in the quantity of demand for new houses will drive prices high in turn this will force home builders to build more homes to match demand. The result is at the end we have an equilibrium whereby demand matches supply at a certain price. In this paper we will discuss in detail factors that influence the movements in the demand and supply curves.
1.2 Key factors that influence home prices
Economic growth and real income
During years of economic boom peoples real incomes increase thus they are much more likely to purchase houses thus prices will be on the upward trend. On the contrary during a recession, people spend less and this will also influence the prices of houses.
Interest Rates
Nowadays most houses are purchased through mortgages or a special kind of loan issued by the bank for one to purchase a house. The Federal Reserve sets the base rates which influences all rates in the financial markets. With lower rates it is easier for people to get mortgages because they will pay less in interest payments and premium thus it serves as an incentive to take mortgage.
Consumer confidence
In recent times this has come to be one of the most determining factors in influencing prices of almost anything. Consumer confidence measures people sentiments about the economy, political environment etc which are influential in them making such decisions. Lower consumer confidence means people will spend less and that may force house prices down.
Inherited Wealth
Some people use money left over when their parents or rich relative dies to purchase houses. Thus even though the price of a house is now so exorbitant as compared to thirty years ago, some people can still purchase them, with income not a determining factor. 2.0 Home prices in the United States pre 2005
As shown in fig.1 between 1999 and 2005 the United States witnessed a housing boom. This is measured using home price index (SPCase-Shiller home price index). The SPCase-Shiller home price index tracks monthly changes in the value of residential real estate in 20 metropolitan regions across the U.S. The composite indexes and the regional indexes are seen by the markets as measuring changes in existing home prices and are based on single-family home resale. The key composite series are for the longer-running, original 10-city composite series and the newer and expanded 20-city composite. A national index is published quarterly. The indexes are based on single-family dwellings with two or more sales transactions. Condominiums and co-ops are excluded as is new construction. The data are compiled for SP by Fiserv, Inc (Fidweek 2009)
2.10 Factors that led to the housing boom
Sub-prime mortgages and interest only loans
This is a situation whereby borrowers with poor credit histories and who are unlikely to be granted credit by any financial institution are given loans bypassing the normal credit issuance procedures. In some cases the borrower may not have any credit history at all. With a subprime mortgage loan, the borrower does not have to pay the principle amount until after a certain number of years. The borrower only pays interest for this loan and is deceived into thinking that the loan is cheap. The borrower may default on the loan later on as they find it difficult to service.
It is no surprise therefore that the peak in housing prices as we have seen earlier was closely related to an increase in the issuance of sub-prime mortgages.
As can be seen in figure 3, the peak in house prices that is in 2005 is also the time at which the highest number of sub-prime mortgage loans (about 21 of all mortgage loans) were issued in US history.
Government policies (deregulation of the financial sector)
Government deregulation and failed regulation of the commercial and investment banking industries were important contributors to the subprime mortgage crisis. These included allowing the self-regulation of Wall Streets investment banks and the failed regulation of Wall Street rating agencies, which were responsible for incorrectly rating some 3.2 trillion dollars of subprime mortgage-backed securities.(Wapedia 2009) The repeal of the Glass Steagall Act, Community Reinvestment Act during president Carter, the Commodity Futures Modernization Act of 2000, the role of Fannie Mae, Freddie Mac and the FHLB and many other policies the United States government pursued helped to fuel a housing boom leading up to 2005.
Unfair and avaricious market practices
This played a very important role in the housing boom and the home market bubble burst which followed it. The increase in popularity of mortgage based securities, hedge funds and CDOs meant that loans changed hands quickly at higher and higher rates. Banks lent out so much money far more than their balance sheets could afford. The assumption was that house prices will continue to rising hence these loans were safe. Home buyers were tricked into getting more mortgages to fuel all these greedy tendencies. All these factors increased demand for new homes as there was a lot of free moving money.
The diagram below shows the increase in demand for new houses as a result of some of the factors mentioned above. The demand curve shifted from D1 to D2 pushing prices from P1 to P2. As prices of houses kept on rising, this fueled further speculation within the financial markets.
The bubble bursts 2005- 2008
What happened between this periods affected prices of new homes immensely and was to have far reaching consequences for the financial sector and the whole economy in general. The diagram below depicts what happened to average home prices as the housing boom lost steam.
The arrow shows a fall in housing prices as the housing market bubble burst. Prices of new homes were to continue this trend till early 2010. In this section we try to look for clues as to what actually transpired leading to such a dip in home prices.
3.10 Cause of the fall in house prices
Between 2005 and 2008 the average price and values of many homes in the United States began to fall. This super scheme which had been created by mortgage brokers whereby people with poor credit records could own houses began to show cracks. Firstly it is important to that it was very difficult to detect anything amiss in the housing market as long as home prices continued in the upward path. Mortgage brokers used to bypass the normal and standard risk and credit checks on clients and offer them loans to purchase houses. There was an incentive on the part of mortgage brokers for them to do so as they will quickly sell these loans to secondary markets. When home prices rose as like was the trend, excess equity was used to finance payments on these mortgages. By late 2005 prices took a dip, some home owners started to default on payments.
As shown in the diagram above the fall in home prices was very drastic if not unprecedented. The diagram compares the trend in home prices in the 90s to what transpired in the three years 2007-2009. First the fall is more gently and it increases in velocity heading towards 2009. The explanation behind all this is that home prices had gone way beyond their market value and there was a need for a market correction.
From the diagram above home prices had reached P2 a price way above the market equilibrium E. As the market started to correct itself home prices began to fall. Panic started to spread in the whole housing market. As more home owners started to default on their payments (they no longer had any equity to finance their mortgages), the number of properties dumped into the market increased.
This increased the supply of houses in the market as shown in fig.8. The result was a further decline in prices and more panic in the housing market.
3.20 Effects of housing market bubble burst
The effects were far reaching and devastating. Within a few weeks after the first signs of sub-prime mortgage crises had been detected, the crises had already begun to spread to other parts of the world. Iceland and the UK were some of the countries which were badly hit. In addition many investments and pension funds were hit. Many banks such as Lehman Brothers went under as they could not absorb all the losses on their balance sheets for all the bad loans they had given.
4.0 Direction of house prices in the future
As depicted in Fig. 6, for 2009 houses prices are already on the rebound. The growth will be as rapid as the pre-housing boom rate because they are so many limiting factors in the market in addition to the many regulations which have been put.
4.10 Main factors fueling current rebound in house prices
Huge stimulus spending. In 2009 the government of president Obama passed the American Recovery and Reinvestment act. In this stimulus spending allocated to housing included
4 billion to the Department of Housing and Urban Development (HUD) for repairing and modernizing public housing, including increasing the energy efficiency of units.
2.25 billion in tax credits for financing low-income housing construction
2 billion for Section 8 housing rental assistance
2 billion to help communities purchase and repair foreclosed housing
1.5 billion for rental assistance and housing relocation
510 million for the rehabilitation of Native American housing
200 million for helping rural Americans buy homes
130 million for rural community facilities
100 million to help remove lead paint from public housing
Adopted from HYPERLINK httpen.wikipedia.orgwikiAmerican_Recovery_and_Reinvestment_Act_of_2009 (Excerpts American_Recovery_and_Reinvestment_Act_of_2009)
The Obama Housing and Home Owner Rescue Plan
This is a plan set up to help innocent victims of the sub-prime mortgage crisis avoid fore-closure. The plan enabled them to renegotiate their mortgage conditions with their mortgage brokers. The plan will also, give cash incentives to your current mortgage holder to modify your ARM loan to a fixed rate loan and reduce the rate. (Ezine Articles 2009) This measure helped to limit foreclosures thus stop home prices from falling further.
General recovery in the United States Economy and in the financial sector
Forecasted economic recovery in the United States economy has boosted confidence in the housing market thus the increase in prices. Furthermore the worst of the financial crises is now over and hence banks have started lending again. Credit is somehow available even though limited, for people to purchase new homes. Thus we should expect a continued rise in house prices.
5.0 Main factors that will determine home prices in future
In this paper a lot has been discussed and said about the events that occurred in the housing market in the past six years, and some predictions have been made about the trend that will be expected in the coming few years. The sub-prime mortgage crises was one of the largest disasters in USA housing history as it deeply stripped many homes of their real values. The current stimulus measures and government reform of banks and other financial institutions will lay the groundwork for a firm and sustained growth in the housing industry. Nevertheless we may be speaking very general here, it is important to know that house prices are to a greater extent also influenced by other major factors such as demographic changes, location and geography, changes in real income etc.