Do you know about - Overuse of Financial Leverage and The Housing accident
Federal Reserve Interest Rate History! Again, for I know. Ready to share new things that are useful. You and your friends.One of the contributing factors to the collapse of the housing market is the collapse of subprime mortgages. After a steady rise in real estate prices even unqualified applicants without a good credit history and cash for down cost in their pockets were able to get subprime mortgages to own a decent house. With the help of poorly regulated financial lending theory it was so easy to get subprime loans with low interest rates and unquestionably no down cost at all.
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When these loans matured their fixed interest rates turned into fluctuating form and the homeowners couldn't afford to pay their high interest mortgages. This triggered a lot of foreclosures in dissimilar parts of Us. These foreclosures of the houses brought down the value of the other houses in their neighborhoods. All of a sudden many homeowners found themselves in a situation where they owe more than the market value of their homes.
Besides subprime mortgages' defaults oversupply of new house constructions added fuel into the flame which spread into the whole country. The mortgage lenders and banks created so much diverse and complicated mortgage options to be able to petition more customers, neither the borrowers nor the mortgage brokers fully understood these options and their terms. These factors triggered the ask which caused a big jump in median home prices in the last decade. When we correlate historical median home prices it clearly explains the whole picture. The increase in median home prices in the middle of 1997 and 2007 is 74% whereas the increase in the middle of 1987 and 1997 is 52%. The bubble in the last decade is unprecedented.
June 1987: ,900
June 1997: 1,400
June 2007: 9,200
This seemingly national housing emergency turned into a worldwide economic emergency as the lenders of these default mortgages were the investors from all over the world, a bank from Australia or an investor from Taiwan. The burst of the ever inflating house bubble caused a domino succeed and created a big worldwide economic downturn. Many banks and financial institutions having big number of mortgage backed securities in their equilibrium sheets, a.k.a. Toxic assets, went out of business. This also created a credit crisis, i.e. The banks slowed the lending activity. credit emergency affected every person who needs a loan to start up a company, go to college or buy an automobile.
We can account for the root cause of this emergency as exploiting and excessively using of financial leverage. The investors were investing in Us treasury bills since it was the safest harbor until when they found out that there was a better return in investing mortgage backed securities. After the dot-com bust and September 11 Federal maintain Chairman Alan Greenspan lowered the interest rates to only 1% to keep the cheaper strong. This low percent interest repelled the investors while attractive the banks.
As the banks could borrow more money with low interest rates, they could use that money to buy mortgages from mortgage lenders and sell them to investors and make money out of this deal. The investors were also happy as they were gaining more return than the Treasury bills. This is practically called financial leverage which means basically borrowing money to amplify the outcome of a deal. High financial leverage put the banks into a higher riskier position. all went well as long as the homeowners were paying their mortgages. But when mortgage defaults started immoderate use of financial leverage put these money production banks into a bad situation.
When person buys "too much house" or refinances, as this means higher fixed cash outflows to maintain a higher mortgage payment, we can view this as higher fixed cost impacting the homeowner's budget. If, compared to fixed costs, variable costs form a relatively smaller measure of the household's total costs; this puts the homeowner into a risky situation due to high operating leverage. The definition of the operating leverage is the ratio of fixed costs to total costs. The higher fixed cost means the higher operating leverage.
Due to high operating leverage, a small decrease in household revenue can jeopardize the financial position of the homeowner which may ultimately end up with a walk away from the house or i.e. Foreclosure. The families having this issue will try to cut the other costs to be able to cover the high fixed costs with their decreasing incomes. Per the "Greater Risk, Greater Return" rule this also means more revenue or equity if all goes fine with the housing market and no concern of unemployment or no decrease in household's income.
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