Global Economic Environment.MBA-FP6008
Monetary Policy: Economic Analysis 4
Explain how each of the following relate to the financial crisis of 2007–2008:
Declines in real estate values– Home prices continued their plunge during the last three months of 2007, setting a real estate trade group’s record for the biggest-ever quarterly drop.
The national median price drop of 5.8%, to $206,200 from $219,300, was the steepest ever recorded by the National Association of Realtors (NAR), which has been compiling the report since 1979.
NAR officials blamed the liquidity squeeze that began last summer for much of the drop. Home buyers had trouble obtaining mortgage financing, especially for more expensive properties (Money.cnn.com, 2018).
Subprime mortgage loans- a type of mortgage that is normally issued by a lending institution to borrowers with low credit ratings. As a result of the borrower’s lower credit rating, a conventional mortgage is not offered because the lender views the borrower as having a larger-than-average risk of defaulting on the loan. Lending institutions often charge interest on subprime mortgages at a rate that is higher than a conventional mortgage in order to compensate themselves for carrying more risk (Staff, 2018).
Mortgage-backed securities- is a type of asset-backed security that is secured by a mortgage or collection of mortgages. The mortgages are sold to a group of individuals (a government agency or investment bank) that securitizes, or packages, the loans together into a security that investors can buy (En.wikipedia.org, 2018).
In 2007-2008 the banking industry issued a large number of loans to borrowers that were relatively more risky in the sense that these borrowers were more likely to default on their loans. This was referred to as the subprime market. This in turn resulted in rapid increase in home prices (along with housing market speculation) that was unstable (sometimes referred to as a bubble). This became more exacerbated by the insurance of mortgage-backed securities, which bundled riskier mortgages together and sold them to inventors. In theory this reduced the risk that the banks faced after giving out the loans. The new found safety in that risk made the banks more comfortable and in turn lead to more subprime mortgage loans. However the reduction in risk was actually an accounting illusion when the banks also started issuing out loans to the companies that were purchasing the mortgage backed securities.
When housing prices started to decline and individuals started to default on their mortgages (subprime borrowers) this reduced if not completely eliminated the value of the mortgage backed securities. This caused the financial investors who held the securities to default in their loans to the bank that originally offered the mortgage backed securities. (Summed up the bank issued loans to those who were buying the assets that they were selling) All of this lead to the banks writing off bad loans and caused a major credit crunch through all the defaults.
Analyze what economists mean when they say that monetary policy can exhibit cyclical asymmetry.
Cyclical asymmetry refers to the condition that a restrictive monetary policy is relatively potent at conducting economic activity, but an expansionary monetary policy is relatively weak stimulating an economy. The weakness in expansionary monetary policy results when, even though the Fed increases liquidity (reserves) in the system potential borrowers are unwilling to spend (often this is due to uncertainty over general weakness in the economy). This is often referred to as a liquidity trap.
Cyclical asymmetry, and the potential for liquidity trap, is important to policymakers because it suggests that while monetary policy can effectively fight inflation, it might not be as successful in bringing an economy out of recession. This was proven by Japan in the 90s due to the fact that expansionary monetary policy may be inadequate and an expansionary fiscal policy may be necessary in order to stimulate recovery.
Money.cnn.com. (2018). Home price declines steepen in fourth quarter – Realtors – Feb. 14, 2008. [online] Available at: http://money.cnn.com/2008/02/14/real_estate/home_prices_fall_for_year/index.htm?postversion=2008021414 [Accessed 23 Jan. 2018].
En.wikipedia.org. (2018). Mortgage-backed security. [online] Available at: https://en.wikipedia.org/wiki/Mortgage-backed_security [Accessed 23 Jan. 2018].
Staff, I. (2018). Housing Bubble. [online] Investopedia. Available at: https://www.investopedia.com/terms/h/housing_bubble.asp?lgl=myfinance-layout-no-ads [Accessed 23 Jan. 2018].
Staff, I. (2018). Subprime Mortgage. [online] Investopedia. Available at: https://www.investopedia.com/terms/s/subprime_mortgage.asp?lgl=myfinance-layout-no-ads [Accessed 23 Jan. 2018].