Dot Com Bust: Starting Point of Subprime Mortgage Crisis
The subprime mortgage crisis is a unique case in the fact that this bubble started from an earlier present bubble in the United States. Many critics argue that the policies enacted by the government to minimize the pain of the aftermath of the dot com bubble burst of the late nineties is the chief cause of the subprime mortgage crisis.
The dot com bubble was a bubble which flourished in the nineties. The internet was an extremely new business and many companies that had leveraged the internet were having multibillion dollar valuations. There came a time when investors were so euphoric about dot com companies that any company could add millions of dollars to its market capitalization by simply adding dot com to its name.
During the late nineties and the first few years of the new millennium, the US economy was constantly hit by adverse events. Some of them were as follows:
- Dot Com Bust: The dot com bust happened sometime in 2001. Investors woke up to the fact that not every company that operates via the internet is going to turn in millions of dollars in profits. They also realized that in the process of acquiring more and more of these dot com companies, they might have inadvertently pushed up the stock prices beyond sustainable limits. Soon came a massive sell off and the United States stock markets were reeling. This created a lack of consumer confidence and consumer spending.
- Enron Scandal: To make matters worse, the biggest corporate fraud in the history of America also unfolded at about the same time. Enron, had been swindling billions of dollars of shareholders money. It had also played with the life savings of thousands of employees. This fraud also came to light in 2001 and the company was declared bankrupt. Enron had been a Fortune 100 company and employed thousands of people. Enron’s bankruptcy plunged the economy into a crisis negatively affecting consumer confidence and consumer spending.
- Hurricane Katrina: The grave natural disaster of hurricane Katrina also struck New Orleans at around the same time. Once again there was large scale destruction of life and property having adverse effects on the United States economy.
- Terrorist Attacks: To add up to all this, the United States was further struck by a terrorist attack on the 11th September 2001. This plunged the nation into war. An overseas war means huge expenses and also huge debt. This also created ripple effects in the economy and there was a loss of consumer confidence.
Low Interest Rates
The United States government was reeling from successive economic blows. The Federal Reserve i.e. the central bank of the United States had to come up with a way to help expand the economy. As a result they resorted to cutting interest rates. Within a two year period, interest rates were cut from 5.75% to 1.25%. This dramatic fall did not happen in a single interest rate cut. Rather a series of interest rate cuts were introduced whenever the monetary policy was announced. These rates were historically very low for the United States and the inflation rate was greater than these interest rates meaning that the real interest rate was negative. The situation was left this way for a few years.
To many observers and critics, this was the death knell. This is what they believe resulted in the subprime mortgage crisis.
Speculative Housing Market Activity
The government did succeed in its goal of increasing spending and reducing monetary turmoil by resorting to interest rate cuts. However, this resulted in speculative activity in the housing market. The details of the same have been outlined below.
- Housing Prices: The housing prices in the United States doubled during the period when interest rates were low. That was a 14% year on year return on the housing prices. Historically, the housing prices in the United States moved at around the rate of inflation. This housing boom was fueled by the sudden availability of a massive amount of credit in the markets. Hence, this could be considered as one of the prime causes of the subprime mortgage crisis.
- Lending Requirements: With the availability of excess money, banks were also forced to lower their lending standards and make unsustainable loans. There was just too much money in the market and banks had to compete to lend that money.
- Mal Investments: The housing boom was indeed a bubble because most of the houses that were sold were not inhabited by people. About 40% of the houses sold during the period were vacation homes. Then, again another 22% were being flipped over and over again by speculators looking to make a quick buck. The actual need i.e. the number of houses where people actually stayed were very less. It was just the easy availability of mortgages to pretty much anybody that pushed the banks into making mal-investments.
The Seeds Were Sown
At the time of the boom, housing prices seemed to be rising. Anybody who was investing ended up making money and all seemed fine. However, it is during this period and because of the low interest rates introduced by the Fed that the seeds of a catastrophe were sown. The subprime mortgage crisis was thus in a way the offshoot of an attempt to avoid the dot com bubble bust.
Authorship/Referencing - About the Author(s)
The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- Subprime Mortgage Crisis: An Introduction
- Dot Com Bust: Starting Point of Subprime Mortgage Crisis
- Political Incentive for Home Ownership
- The Case Of Freddie Mac, Fannie Mae and Ginnie Mae
- Advantages to Freddie Mac, Fannie Man and Ginnie Mae
- Types of Mortgages
- Types of Mortgages from Borrowers Point of View
- Mortgage Products - Negative Amortization & Home Equity Line of Credit
- The New Mortgage Landscape
- The New Mortgage Landscape: Conflict of Interest
- New Age Financial Securities - Mortgage Backed Securities & Credit Default Swaps
- Collateralized Debt Obligations and Tranching
- Benefits of Collateralized Debt Obligation (CDO’s)
- Subprime Crisis: Problems Caused by Accounting
- The Self Reinforcing Housing Loop
- Integrated Financial Systems
- Credit Market Freeze
- Borrower Approach vs Collateral Approach
- How Reverse Mortgage Works ?
- Reverse Mortgage: Pros and Cons
- The Big Bust – Washington Mutual (WaMu)
- General Motors and the Subprime Crisis
- The Return of Subprime Mortgages
- The Big Subprime Bust
- Executive Compensation and Sub-Prime Mortgage Crisis
- The Big Fall: Lehman Brothers
- The Big Fall: Bear Stearns