US sub prime crisis

Topic: Discuss the reasons for problems encountered in the US and global housing market. What impacts might these problems have on global business activity? Explain your reasoning. Use specific examples to illustrate your arguments wherever possible. Introduction This essay aims to initially introduce the reader to the global housing activity and the bubble that it has been experiencing since 2003 due to the US sub prime crisis. This will be achieved by critically evaluating relevant literature, articles and graphs and by explaining the crisis' effect on the UK economy.

Suggestions for the both the UK and US economies' recovery will also be discussed using as examples Kate Barker's Review of Housing Supply, the formation of the US's Master Liquidity Enhancement Conduit as well as the use of self investment and real estate funds. In 2003 the global housing market was exposed to a great jolt because of the United States' (US) sub prime crisis. The Bank of America had more than $15 billion in net exposure to Collateralised Debt Obligations (CDOs) of which $12 billion were supported by sub prime mortgages.

According to Hamish McRae (2007, online) 85% of the US housing market belonged to second hand house sales and the US had a current account deficit of $649. 698 million which was 6% of its Gross Domestic Product (GDP) which was $10828. 3 billion. Since 2003 the sub prime crisis has raised uncertainty about the global economy creating even more worries about further oil price shocks as well as shocks about growth and inflation. Sub prime, means the low prices in mortgages and loans in the US in 2003 due to the low interest rates which were at the time 1%. According to an article by John Smith posted on www.

ukpersonalloan. co. uk (15 August 2007, online) the reason that US interest rates were so low was because the Federal Reserve was trying to block out the booming Japanese and Chinese economies that were trying to enter the American economy by exporting materials and goods in the US. They also wanted to keep their currencies relatively fixed against the US Dollar. These two factors led American banks to start granting loans to almost anybody and especially to people with low wages who used their homes as collateral including giving mortgages to people living in Florida's poorest areas and trailer parks.

The fall of the interest rates in 2003 also resulted to very low house prices making it easier for people to afford mortgages that could not be afforded before, helping them to buy houses at much lower prices. As a result of current interest rates which are now 5. 25% (Smith15 August 2007, online), there has been a huge number of repossessions as well as a lowering of the country's Withdrawals and Injections. As shown on Graph 1 an increase on interest rates lowers the country's Withdrawals and Injections. According to Griffiths (2005) Injections (J) and Withdrawals (W) are parts of the circular flow of an economy.

Injections are the Investments (I), Exports(X) and Government Spending (G) of a country and that interest rates have a negative effect on investments thus when interest rates are increasing investments are decreasing. On the other hand, Withdrawals are the country's National Income (Y), Taxation (T) and Savings (S). Griffiths (2005) argues that an increase in interest rates causes the population of a country to increase household savings thus reducing its withdrawals. Graph 1: Decrease in injections from J1 to J2 (Griffiths 2005)

Due to the huge number of repossessions and the fact that 80% of the CDOs were mortgages, many believe that the US balance of payments deficit is unsustainable and the United Kingdom's (UK) government worry about its housing market's response, as it is one of the UK's money making machines, and the government's response on the Barker Review of Housing Supply. Kate Barker is the author of the Barker Review of Housing Supply and a member and Chief Economist of the Bank of England's Monetary Policy Committee (MPC) which sets interest rates in the UK in order to keep the targeted inflation rate (2%).

The other reason that the global economy was stricken by this crisis was that most US banks sold these CDOs to the global market. According to John Spence (13 November 2007, online) CDOs are corporate bonds, mortgages, high interest loans and derivatives that are packed together and sold by the banks through the global market to large investors and other banks. The main reason that CDOs are considered smart investments is very simple and is also the reason that made the entire economy suffer. CDOs have an AAA-credit rating in the stock market.

This means that by investing in AAA funds such as CDOs you have more chance of generating more money than in investing in a small independent company or stock. As we can see, due to the CDOs' AAA-credit rating it was only reasonable for British and European banks to buy most of the funds thinking of them as less risky investments, buying large pieces of land at low cost or investing in funds that are capital protected or investing in large funds with low possibilities of failing, being unaware that they would actually end up owning some of the poorest areas in the US.

In an attempt to explain the American banks' behaviour, Heather Stewart, economics correspondent of The Observer argues that Americans think that a weakening property/capital market can not be a threat to the global economy and therefore does not care about it as long as everything is managed correctly by the relevant authorities and their country is not affected to a large extent by the rest of the economies. Strangely enough due to this crisis according to the Guardian it is estimated that at least 73,000 people in the housing market will lose their jobs per month solely in the US.

Also, Stephen Roach, chief economist at Morgan Stanley predicts that the US GDP will be lowered by at least 2% from $10828. 3 billion to $8662. 64 billion, taking the US economy close to recession. According to a UK estate agency (John D Wood & CO, 2007, online), the UK economy on the other hand has developed pretty well, since 1997. When the Bank of England was granted full independence the international credibility of fiscal policy changed, helping it in many ways.

The relative flexibility of labour and product markets combined with the usage of English as the main language of most financial services has helped the UK to run a large balance of payments as well as trade deficits without depreciating its currency. It has also helped lower unemployment and its house to price income ratios (HTIR) to a new level. The HTIR is the percentage of the median house prices over the median of disposable incomes, and is the key factor to mortgage lending decisions.

John D Wood & CO has also conducted a review on the UK and global housing market arguing that the sub prime crisis in 2003 in association with credit market liberalisation which is the many-fold expansion of international capital flows relative to world output, lower inflation variability, nominal interest rates, as well as real rates, lower mortgage default rates and the low rate of unemployment in the UK (5. 2%) resulted in an increase of the percentage of HTIR from 54% since 1980 to 63% in 2003 and the FTSE 100 fall from 6,700 to 6,038.

This increase of the HTIR means that mortgages in the UK are much higher than the average UK employee's household income. The HTIR increase and the variation of credit cards and unsecured debt that an interested house buyer can have has created an illusionary wealth and produced never seen before imbalances and bubbles in the economy and the sub prime market. As a result, there is distrust between everyone dealing in housing especially between banks and any kind of customer either house buyer or firm and a fall of loan limits has been applied towards first time house buyers creating a credit crunch over the UK.

'A credit crunch is a recessionary period in a debt based monetary system where growth in credit has slowed and subsequently caused a drying up of liquidity in an economy' (www. creditcrunch. co. uk, 27 October 2007). Another reason that the UK economy was affected by the sub prime crisis was that the rate of demand and supply in flats, houses and available land for housing has changed over the last 10 years. Listed below is a graph that indicates the elasticity and trends of the housing market in the UK.