By: Dr. Khaled K. Abdou, Assistant Professor of Financial Services
Anywhere you go, you will find people talking about the economy, the drop in the stock market, the increasing prices of durable goods, and the cost of living. People are intently watching financial news channels, reading newspapers, and listening to broadcasts in an attempt to comprehend and stay current with the economic changes that are taking place at rocket speed. This intense interest stems from the uncertainty about the future, their financial well-being, and the market value of their portfolios.
This upsetting news triggers several questions that this article will attempt to address, including: How did we get into this mess? Who is affected by this crisis? And, especially, now what?
How did we get into this mess?
Low interest rates in 2001 coupled with soaring prices from real estate resulted in three groups becoming interested in such a profitable market: homebuyers, speculators, and mortgage brokers.
The idea was to get a loan (mortgage) and buy a house, own it for a short period of time, possibly make improvements, then “flip it” and make a significant profit. At the time, it was very easy to qualify for a mortgage and even homebuyers with limited means could qualify for a mortgage that often exceeded their ability to pay, all based on the premise that the property would increase in value and be sold for a profit, allowing the homebuyer to pay their mortgage in full.
Also, in certain states such as California and Florida, the housing market was showing unprecedented , dramatic price increases, and as a result, homebuyers as well as speculators engaged in buying properties. Some wanted to maximize their profits even further, so they used an Adjustable Rate Mortgage (ARM) to finance their home purchase. An ARM is characterized by low fixed interest rates (teaser rates) in the first few years followed by variable rates, which were adjusted regularly to the market interest rate plus a mark-up.
Unfortuantely, the prices in the real estate market did not move as expected; rather they plummeted dramatically. This has affected both new home sales and sales of existing home, and subsequently, home builders and mortgage lenders.
At Penn State Berks, Dr. Sudip Ghosh, Assistant Professor of Business, and I are researching whether insiders, using their information in the home builders’ industry, were able to forecast this crisis and sell their stocks before the stock market was able to forecast the decline.
To complete this cycle, securitization of these debts were needed. In other words, these mortgages were pooled together using sophisticated financial modeling to create a new financial security called a Mortgage-Backed Security (MBS). These securities were created by large financial institutions such as Freddie Mac and Fannie Mae.
Each MBS had distinct characteristics and risk profiles based on the financial model. These mortgage-backed securities were then sold in the open market. Portfolio managers, financial institutions, and international investors bought and sold these securities in a liquid market. Therefore, although a company may not have lent directly to homebuyers, they were still affected by the financial crisis if they held these securities.
Who is affected by the crisis?
A domino effect is now in play, and in the U.S. the financial sector is not the only sector that is suffering. Since consumers/homeowners feel the pinch, they are hesitant to spend. This feeling is exacerbated by the uncertainty they feel about the economy. At the same time, financial institutions that hold Mortgage-Backed Securities worth billions of dollars are incurring losses due to the decrease in market value of their MBS holding. Hence, other sectors are also affected by the declining consumer demand, which in turn, triggers cost cutting and layoffs. This affects demand for oil, commodities, and trade with the rest of the world.Internationally, foreign countries are also feeling the crunch because their financial institutions also hold these bad assets and they are additionally affected by the declining demand for goods within the U.S. economy.
Now What?
With strapped credit markets, financial institutions are reluctant to lend to each other or to issue new loans for homebuyers. Central banks around the world and the Federal Reserve Bank (FRB) are now working closely to avoid a long and deep recession. recession is defined as “a decline in real Gross Domestic Product (GDP) lasting two consecutive quarters.”
At Penn State Berks, Dr. Jui-Chi Huang, Assistant Professor of Economics, is researching how to observe a recession earlier than the manner that has been followed in the past.
The central banks and FRB are cutting interest rates and injecting billions of dollars into the markets in order to thaw the credit markets. Also, economic stimulus packages are currently being used by many countries to help stimulate the economy. For example, in the U.S., a $700 billion stimulus plan was approved; Japan unveiled a stimulus package worth 5 trillion yen ($51.5 billion); and Chinia has announced a huge stimulus plan worth 4 trillion yuan ($586 billion).
These significant government interventions to stabilize the worldwide economies are meant to avoid a bigger crisis such as the Great Depression. These are, in my opinion, necessary to regain confidence in the worldwide financial system and boost consumer confidence. Whether they are sufficient or not will be determined in the coming months.
In conclusion, the whole world is now suffering from a major financial crisis. All regulatory bodies, including central banks, the FRB, and the International Monetary Fund are using classic, as well as innovative tools in an attempt to stabilize the financial markets. In the next few months, we expect to assess whether those interventions were necessary and sufficient or whether further steps will be needed to address this unprecedented economic turmoil.