Microeconomics Study Set 47

Business

Quiz 21 :

The Crisis of 2008: Causes and Lessons for the Future.

Quiz 21 :

The Crisis of 2008: Causes and Lessons for the Future.

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Why did housing prices rise rapidly during 2002- 2005 Why did the mortgage default rate increase so sharply during 2006 and 2007 even before the 2008- 2009 recession began
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Housing prices rose rapidly during 2002-2005 because of housing boom caused by surge in housing demand. The surge in the housing demand was the result of mix of factors. These were as follows:
a) The decline in the mortgage lending standards by the lenders due to relaxation of rules by the Government Sponsored Enterprises (GSEs) and Community Reinvestment Act (CRA).
b) The lower down payment requirements mandated by the regulatory agencies to promote house ownership led to surge in subprime borrowers.
c) Easy monetary policy of the Fed made the interest rate artificially low. This increased the attractiveness (or demand) of the interest-sensitive housing sector and the Adjustable Rate Mortgages (ARM).
d) The relaxation of rules by the Securities and Exchange Commission (SEC) led to high leverage by investment banks.
e) High debt-to-income ratio of the households on account of easing of lending standards.
The mortgage default rate increased sharply even before the crisis because of
1) Increase in interest rates by Fed to control inflation (which was a consequence of artificial low interest rate regime during 2002-2004); and
2) Decline in the housing prices during the second half of 2006
The increase in the mortgage default rates of the subprime and prime borrowers led to housing crisis. As the housing crisis spread to other sectors, stock markets crashed, and investment banks faced financial troubles. The net result was declined in employment and the onset of economy-wide crisis in 2008.
The increase in the mortgage default rates prior to the onset of economic crisis indicates that it was housing crisis that caused the recession

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What happened to the credit standards (e.g., minimum down payment, mortgage loan relative to the value of the house, and creditworthiness of the borrower) between 1995 and 2005 Why did the credit standards change How did this influence the housing price bubble and later the default and foreclosure rates
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Between 1995 and 2005, credit standards declined. This reflected in lowering of minimum down payments standards and extending of loans to subprime borrowers and consequently increase in the share of subprime borrowers. Further, no proper evaluation of the creditworthiness of borrowers was done. This is reflected by the increase in Alt A loans (loans extended without full documentation). The combination of all these led to increase in mortgage loans in relation to income.
The decline in the credit standards was a part of deliberate policy of federal authorities pursued since the mid-1990s to promote house ownership to the low-income class people. In order to achieve this GSEs and CRA relaxed regulations and rules relating to credit standards.

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*If owners have little or no equity in their houses, how will this influence the likelihood that they will default on their mortgage Why
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The presence of less equity among the owners will increase the rate of default on mortgages. This is because most of the mortgages of houses in the United States are in the nature of recourse loan wherein the owner is accountable for the debt beyond returning the property to the lender if default happens. On the other hand, the lender can make no claim legally beyond the mortgaged asset. Thus, with the fall in the value of the home below the loan which is outstanding, the borrower gains by simply leaving the property.

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When did mortgage default and housing foreclosure rates begin to rise rapidly When did the economy go into recession Was there a causal relationship between the two Discuss.
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*When mortgage originators sell mortgages to Fannie Mae, Freddie Mac, and investment banks the originators have no additional liability for possible default by the borrower. How will this arrangement influence the incentive of the originators to scrutinize the creditworthiness of the borrower Would the incentive structure be different if the originator planned to hold the mortgage until it was paid off Why or why not
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Some charge that the Crisis of 2008 was caused by the "greed" of Wall Street firms and other bankers. Do you agree with this view Do you think there was more greed on Wall Street in the first five years of this century than during the 1980s and 1990s Why or why not *Asterisk denotes questions for which answers are given in Appendix B.
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