Keynesian Economics and the Mortgage Crisis

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Keynesian Economics and the Mortgage Crisis
The recent mortgage crisis in the US was unprecedented. It led to a massive clampdown of financial institutions, occasioning one of the worst financial melt-downs the US has ever faced (Jaffe, 2008). Quite naturally, it would be necessary to examine the cause of the crisis in order to draft prophylactic measures that would prevent the same financial disaster in the future. This paper will discuss the events that led to the mortgage crisis. The housing bubble

One of the factors that led to the mortgage crisis was the housing bubble. It started in 2001 and climaxed in 2005. A housing bubble is characterized by rapid increase in the value of real estate properties to an extent that it can no longer be sustained. Prices of real estate property are driven through the roof, well beyond the affordability of the people as their incomes remain fixed. These increases result into a decrease in home prices, resulting into mortgages that were higher than the value of the property. Housing bubbles occurred in the US in 2006 and were not detected until it was too late. During this time, home values were already overpriced. Economists warned that market correction could take years and would cost trillions of dollars in its wake. They further warned of massive drops in home values, much more than it was being expected. The worst inevitably happened and the bubble burst. Many people had taken mortgages whose values were much higher than usual. Eventually, most of the mortgage takers saw no need to continue paying out their mortgages when their values of the homes had dropped drastically. The big banks that had bought all those mortgages suddenly hit rock-bottom when home owners started defaulting on payments. This eventually led to the mortgage crisis. Historically low interest rates

Another event that could have precipitated the mortgage crisis was the extra-ordinarily low interest rates that hit the US in 2000. This occurred when the dot.com bubble crumbled, followed by a recession that began in 2001. Investors who were buying treasury bills pulled out when the interest rates fell to just 1%. They; therefore, pumped their moneys into the housing business, raising the stakes. Housing prices are like any other assets and as a result, they are directly affected by the prevailing interest rates. Lower interest rates would lead to increased housing prices as many investors would channel their attention into the home ownership business. Lower interest rates also resulted into increased liquidity on the market. In fact, in some countries, the housing sector is a very crucial aspect of monetary policy management (Bernanke, 2007). Housing market correction

Due to the overpricing of homes during the bubble period, many economists had predicted a possible housing market correction in due time. A Yale University economist even warned of an impending decline in home prices. Others had foreseen a vast depreciation which would soon befall the US economy. However, the expected market correction was long in coming. Housing market correction was widely expected to range from a few points to as much as 50% from peak values. Rise of subprime lending

Perhaps one of the greatest causes of the mortgage crisis was the increase in subprime lending. During the bubble years, there was a heavy subprime borrowing which increased the demand for housing (Bianco, 2008). This is because it pumped a lot of money into circulation, enabling many people to take mortgages. In fact, some property owners took advantage of the situation to borrow more money in order to refinance their mortgages. When the housing bubble crashed, there were high default rates on subprime mortgages. The borrowers had a clean bill of health and therefore, qualified for the loans but the mortgage had assumed a rather risky profile. Factors that were considered included higher loan...
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