The Real Estate Bubble
People who suffered through the 2008 financial crisis were afraid of something similar happening again in 2017. But everything went better than expected, and the market did not crash. Reason for that is, because the causes that leaded to the first crash were no longer present. There were no more credit default swaps which were insured by derivatives such as mortgage- backed securities. In 2008, hedge fund managers created a demand that was thought to be risk-free with securities. That resulted in a huge demand for mortgages.
Because the demand wasso high, banks had to offer loans to basically everyone who wanted to get one.That’s how they created the subprime mortgage crisis in 2006. Many buyers who were not qualified for mortgage entered the market. They bought properties as aninvestment hoping to sell when the prices eventually go up. In 2006, construction finally caught up with the demand, and so the supply outpaced thedemand, ad that resulted in prices falling very quickly, and devaluing theas set market.
National Realtors Association reported that this is the first time in 11 years that a price drop happened. The Federal Reserve (Fed) ignored this warning and thought that it’s possible to pull this situation out of the slump. It saidthat reasons behind are low inflation and increased consumerism. It offered tolower interest rates to give the economy enough liquidity, to support market growth.
The Fed had not noticed any signs of the bubble bursting until March of 2007. They came to the realization, that hedge fund house losses can do a lot of damage to the economy. On the summer of 2007 banks stopped lending money to each other. They were afraid to have bad mortgage as security for the loan in return. They did not know their own debt. Everyone was silent and did not want to admit it, because then their credit rating would be lowered, stock prices would fall, andthey would not be able to raise more funding to stay in business.
By August, Fed needed to loan banks $75 billion because credit became very tight. They tried torestore the liquidity of the banks, to deal with their losses and get back tothe business of giving out loans. What happened was totally different, banks just stopped lending to almost everyone entirely. Because banks cut back on mortgages, property prices fell further. That made borrowers stop paying their debts off, which increased bad loans on the bank’s books. That made banks lendout even less money than before.
So, what happens when banks stop lending money?
A bank’s main incomesource is lending out money. It of course provides other services like wealth management, payments etc., but by taking deposits from their customers and markets, it sets aside a part of those for liquidity and cash ratios, everything that is left after that, is lent out and the bank receives percentages for it. Imagine that you’re not receiving your main paycheck every month, the same thing happens if a bank stops lending money. Today everything lookslike it’s back to normal, banks got their liquidity back, and people are taking mortgages and paying off their debts. But another crash is imminent, you willbe able to find reasons why in the upcoming posts.