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Downturn in U.S. Housing Market Shakes Financial Markets Around the World

by Adam Price |
August 20, 2007
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San Jose, CA - In July the U.S. housing market hit new lows, with the lowest number of permits for new homes and the lowest number of construction starts in more than ten years. Then in August financial markets across the globe were shaken by the growing defaults on mortgages in the United States.

Despite statements from the Bush administration and the U.S. Federal Reserve that the problem was “contained” to so-called “sub-prime mortgages” and despite over $300 billion of cash put into the banking system by European and other central banks, the crisis continued to spread and worsen.

In turn these problems in the financial markets are making it harder to buy homes as interest rates on mortgages rise and mortgages are harder to get, so the downturn in sales and prices of homes in the United States is all but certain to get worse. As the housing market woes spread to other parts of the economy, the possibility of an economic recession in the near future grows.

Over the past five years the United States has had the greatest boom in home prices and sales ever. This boom was fed by low interest rates set by the U.S. Federal Reserve and a host of new mortgage products combining variable interest rates, no down payments and little or no documentation of the borrower’s income. By 2005 there were few renters who could afford to buy homes. But rather than cut back on lending, banks and mortgage companies made many loans to people who really couldn’t afford to pay the mortgages, thinking that rising home prices would allow the borrowers to resell the home or refinance the loan.

But as home prices began to level off and then fall in 2006 and 2007, more and more homebuyers began to fall behind on their mortgage payments and then lose their homes to foreclosure. The rising loan defaults first hit mortgage companies, which began to go belly-up. Then a couple of hedge funds (investment pools aimed at wealthy individuals and institutions such as pension funds) owned by the investment bank Bear Stearns that had borrowed money to buy mortgages failed. This was followed a few days later by the failure of a hedge fund in France owned by a large bank.

These failures triggered a state of near panic where financial companies and wealthy investors didn’t want to loan money at all. The European Central Bank put over $200 billion into the banking system - almost three times as much as on September 12, 2001 - and other central banks, including the U.S. Federal Reserve put in smaller amounts. While this calmed the markets for a few days, problems continued to spread, first to mutual funds (pools of investments) and then to the commercial paper (short-term loans to businesses) market in Canada.

The slowdown in lending also began to affect so-called ‘jumbo’ mortgages, for more than $417,000. This is putting a crimp on the higher end of the housing market, which had been holding up better since these borrowers tend to have higher incomes.

Homeowners are also finding it harder or even impossible to refinance their homes or take out home equity loans. This in turn is putting a damper on consumer sales, with some of the largest retailers such as Wal-Mart and Home Depot lowering their expected future sales and profits. Layoffs and the unemployment rate, while still relatively low, have begun to rise.

Then on Aug. 17, the Federal Reserve lowered the discount rate by one-half a percentage point, to 5.75%. The discount rate is the interest rate that the Federal Reserve charges to make loans to commercial banks. While this caused a sharp rise in stock markets that day, it is not clear that this act will actually mean more credit will be available, since U.S. banks rarely borrow from the Federal Reserve. And even if the Federal Reserve is able to calm the credit markets, the crisis of overproduction could continue to grow, since the fundamental problem is not a lack of credit, but a lack of income to pay for the growing supply of expensive homes that continue to come on to the market.

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