Interest rates and forecasts of their future value are important inputs into an investment decision. Following the lowered interested rates by the Federal Reserve, new financial institutions emerged and competed with the existing lending institutions by offering loans on cheaper terms. Rising house prices together with low interest rates have boosted mortgage refinancing activities, encouraged consumer spending and supported macroeconomic performance (Zhu:2003, 9).
As competition among lenders intensified and more resources for financing real estate became available, the number of potential investors in the real estate sector increased. These lenders submitted to subprime loans and lent to people with less that top credit rating (Hagerty:2007). These people have low credit scores with high debt in relation to income (Haggerty: 2007). This was encouraged by improvements in the overall economic conditions that tend to increase the average income of households (Zhu: 2003, 9)
This causes a housing bubble to occur. A bubble occurs when people buy an asset because its price is rising, and that pulls more buyers into the market causing prices to rise without regard to the real value of the asset (Weisbrot, 2004).
Unfortunately, since 1995, housing prices have increased more than 35 percentage points beyond the overall rate of inflation (Weisbrot, 2004). In contrast, from 1951 1995, they increased at the same rate as inflation (Weisbrot, 2004). Since inflation has been rising, the Consumer Price Index is up 3.7%. The Consumer Price Index (CPI) measures purchasing power by averaging the prices of goods and services in the consumption basket of an urban family of four (Bodie et al, 2005, 138).
In the wake of defaults, lenders become more cautious so people who want to buy homes find it impossible to get loans on reasonable terms (Hagerty: 2007). Moreover, the rise in foreclosure adds supply to the rising market causing prices to fall (Hagerty: 2007). The National Association of Realtors (NAR) projected that existing home prices will slip 0.7% in 2007 (Ossinger: 2007). They say that tighter lending standards and the fallout from troubles with subprime mortgages contribute to the softening of the market.
The No. 2 subprime mortgage lender New Century filed for bankruptcy protection on April 2, 2007, while the No. 1 subprime lender, HSBC, has taken $10.6 billion charge for bad loans, primarily in its US mortgage unit. This is not favorable to the stock market that relies heavily on high expectations. However, lower expectations* have taken precedence and this is what weighs heavily on the Dow.
Realtors expect the first nationwide drop in home prices this year since the Great Depression.
Lenders’ tighter credit in the wake of the subprime-mortgage rout is making it harder for some people to buy homes.
Rising foreclosures will add to supply in some glutted markets.
Realtors are seeking more- lenient terms for borrowers to qualify for Federal Housing Administration-backed loans.” (Hagerty: 2007)
Bodie, et al. Investments. 6th ed. McGraw-Hill/Irwin. New York: 2005
Hagerty, James. Realtors Forecast Falling Home Prices. April 12, 2007. Retrieved on 04/13/07 from www.wsj.com
Ossinger, Joanna. Dow Tumbles 89 on Fed, Housing. April 11, 2007. Retrieved on 04/13/07 from www.wsj.com
Weisbrot, Mark. The Sequel to the Stock Market Bubble: The Housing Bubble. Retrieved on 04/13/07 from http://www.cepr.net/columns/weisbrot/housing_bubble.htm
Zhu, Haibin. The importance of property markets for monetary policy and financial stability. BIS Papers No. 21. Retrieved on 04/13/07 from www.imf.org