A Brief Overview of the Subprime Crisis

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Group Assignment: Understanding Cause of the Subprime Crisis

Prepared by
Kumi Takeda
Jocelyn Hao
Hasanov (Dima) Dilshodbek
Arvin Leow

1. Introduction

The Global Financial Crisis of the late 2000s, triggered by the US subprime mortgage fiasco, severely hit the world economy. It has cost countries and companies billions of dollars and has forced thousands of people out of job around the world. Five years since the burst of the US housing market, butterfly effect of the subprime crisis is still salient and profound as European countries struggle to resolve their sovereign debt crisis. This paper will examine how the US housing market had come to play a role as the epicenter of the global financial crisis. It will illustrate state of the US housing market before the subprime crisis followed by detailed analysis on cause of the crisis.

2. US Housing Market before the Subprime Crisis

Home Price Trend
The S&P/Case-Shiller US Home Price index, the country’s leading home price index, shows that before the housing market burst with the subprime crisis, US home prices had only briefly declined in the late1990 when the country was suffering from a mild recession. The dip was short-lived however, and another upward trend of housing price began in 1991 at an increasing pace over more than a decade until it recorded a 15.68% year-on-year rise in the first quarter of 2005. In fact, the US had never seen any annual decline of more than 5% in the housing market since the Great Depression (L. G. McDonald & P. Robinson, 2009, ‘A Colosal Failure of Common Sense’, p.112). Since 1995, the real home prices ran up by over 35% in a little less than 10 years (J. McCarthy & R. W. Peach, 2004, ‘Are Home Prices the Next “Bubble”?’, Federal Reserve Bank of New York, p.1). To many people, the run of the housing market looked to continue for a while.

S&P/Case-Shiller Home Price Index (Source: Bloomberg)


Growth in US Homeownership
In the early 2000s, the US consumers were enjoying easy credit due to the then lowest level of Federal funds target rate guided at 1% and huge inflows of capital from overseas. The US outstanding household debt which was $4.85 trillion in 1995 (65.5% of GDP), amounted to $12.4 trillion (93% of GDP) by the mid 2006 when the housing market was at its peak (Source: Bloomberg). During a similar period (1994-3Q2005), the US household debt as a percentage of annual personal disposable income climbed to 126% from 88% (M. Bush & J. Katz, 2006, ‘Reinvestment Alert’, Woodstock Institute, p.1). A substantial portion of the household debts went to finance home purchases. In a little over a decade between 1995 and 2005, total amount of mortgage originations saw more than a 350% increase from $640 billion to $2.9 trillion (Source: Mortgage Bankers Association of America, Washington, DC,‘1-4 Family Mortgage Originations 1990-2005’). Total outstanding mortgage debts for 1-to-4 family houses increased from $3.5 trillion (72% of the household debts) to in 1995 to $9.3 trillion (75%) in 2005 (Source: The US Census Bureau, www.census.gov/compendia/statab/2011/tables/11s1191.pdf). As a result of the mortgage market expansion, the US housing ownership rate, which had been stagnated at around 64% for decades, started rising in the mid 1995 and reached 69% in 2004 (Source: Bloomberg). Considering the US household numbers increased from 98.99 million to 112 million between the same period (U.S. Census Bureau, Current Population Reports. From Statistical Abstract of the United States, 2008), the figures are read that US homeownership increased by 13.9 million.

Housing market speculation
Some argue that speculative demands also fueled the home price rise. While the housing market continued to rise at the average of 11.34% each year in the early 2000s, the US stock market was stagnant following the end of the dot.com bubble in 2000. The bond market was also not offering attractive coupons/yields to investors...
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