Within the subprime mortgage crisis, the interest rate has played an important role in causing the mortgage rate decrease and excessive bank credit leading to the price skyrocketing. To take control over the inflation increase, the Federal Funds have decided to lift the interest rates. Currently, the mortgage price has been dramatically gone up which, in its turn, has increased the chances of default. The given empirical discussion is devoted to the consideration of the possible connection between low-interest rates and house prices. All studies present the model of growth and decay.
For accurate results, the researchers make use of the empirical model put forward by radical pragmatism that gives priority to data. In particular, Ayuso et al. (2006) provide different model equations and descriptions where the obtained results are applied to the problem-solving. The researchers have introduced house price modeling with the help of the financial approach (Ayuso et al., 2006, p. 3). This approach can be revealed when on the example on Gordon discount model where the house prices are derived from future real rents where D is real rents and P is house price, r refers to risk-free real interest rate and, finally, RP stands for risk-premium and d is the further growth of real rents rate. This expression explicitly shows the relation between the considered issues.
Studying the scientific papers dedicated to the analysis of house prices, a special consideration requires the research conducted by Ayuso et al. (2006) who argue that monetary policy and interest rates decrease in particular, significantly influence the house price boom. The analysis of the empirical results shows that low-interest rates constitute the key variable determining the credit policy in Spain. It has been found out that a steady level of credit development “is negatively related to nominal interest rates …and unemployment and positively related to spending” (Ayuso et al., 2006, p. 11). The above data can be supported with other persuasive facts and theories presented by the scientific work called Historical monetary policy analysis and the Taylor rule (Orphanides, 2003).
The research presents Taylor’s effective financial policies and proves that policy evaluation is primarily based on the nominal interest rate. In addition, the scholar considers this policy through the prism of economic growth and inflation development influencing the evolution of monetary policy. The scientific work under consideration is an example of the empirical model of growth and decay. In this particular case, the presented calculations revealing the basics of Taylor’s rule are more associated with the model of growth whose main purpose is to distinguish the truth out of false assumptions. The bear formula looks as follows:
i – i * = θ (z – z*)
By the above, the relation between inflation and output will be presented in the following way:
i – i = θ((π+q) –(π* +q *))
Judging on different interpretations of the presented theoretical concepts, it is possible to assume that monetary policy is the key variable that is, therefore, affected by other nuances like house price increase and economic development. Besides, the housing industry was one of the sectors experiencing a significant interest rate reduction with integrated teaser rates.
Gramlich (2007) and Haffer (2005) have also attributed their empirical discussions to the model of growth. Hence, they have presented numerical data, curves, and statistics aimed at defining augmentations and recessions. Further considerations prove the above facts.
Gramlich (2007) points out that a turning point occurred within the US housing industry in 2006. This has led to the augmentation of interest rates due to the incorporation of the Adjustable Rate Mortgage concept (Gramlich, 2007). By 2006, the rate of interest was adjusted to approximately 5.25% and 6% representing a significant increase of interest payment about the fact that the subprime mortgage holders paid approximately 3% during the first five years (Gramlich, 2007, p.11).
According to Haffer (2005), the Federal Reserve implemented an expansionary monetary policy. This was conducted through an aggressive reduction in the interest rate at the onset of the decade. To stimulate the country’s economic growth, the Federal Reserve prolonged its low-interest-rate policy up to 2004. The result was an increment in demand for housing as individuals considered investing in the real estate sector to be the most appropriate. The rise in demand culminated in an increase in housing prices.
Scanlon and Whitehead (2004) have defined that a reduced interest rate stimulates the growth of various economic sectors including the housing sector as well. Higher interest rates have been integrated into the US real estate sector. Hence, in 2003, the Federal Reserve interest rate was 1%, which is rather low (Scanlon and Whitehead, 2004). This insufficient percentage level contributed greatly to the development of the mortgage market. The low interest rate has also coupled with low down payment requirements making adjustable loans very attractive to investors.
According to Hoffinger (2009), a low-interest rate contributes to the country’s economic growth that culminates into an economic expansion. This is explained by the increase of that liquidity amongst financial institutions. The outcome of this action is that financial institutions start to advance credit services to individuals whose creditworthiness is not sufficient. Chomsisengphet and Pennington-Cross (2009) argue that an increase in the rate of interest was accompanied by a decline in the real property price. As a result, the increment of the default level has led to mortgage holders pressurizing originators to purchase all non-performing mortgages.
The researchers put forward the idea that the small lenders who cannot meet the repurchase demands are forced to file for bankruptcy. Such a situation greatly contributes to the occurrence of the subprime crisis. This was also evident in Britain. Reduction in bank rates of interest resulted in increased economic growth (Chomsisengphet and Pennington-Cross, 2009, p. 32). In addition the proliferation of the subprime crediting has deposited to the rise of delinquency. To be more precise, the researchers have marked that 2002 witnessed a 5 times higher delinquency rate among subprime borrowers as compared with prime loan. These empirical data proves that connection between low interest rates and high house prices.
As a result of low interest rates, financial institutions which were issuing mortgages decreased their lending standards due to increased demand. Chomsisengphet and Pennington-Cross (2009) assert that the spread between subprime and prime mortgages reduced from 2.8% to approximately 0.6% from 2001 to 2004. This clearly indicates that demand as compared with securitized mortgages. Additionally, subprime mortgage market is composed of Alt-A loans, subprime and near prime mortgages experienced explosive growth during the period ranging from 2001 to 2006 (Chomsisengphet and Pennington-Cross, 2009, p.33).
During the past decade, there has been significant growth of band crediting. By increasing banks liquidity, the banks lending capacity is increased as well. One of these forms of credit affected by increased bank liquidity includes the mortgages. As a result, mortgage credit rates prevail in comparison with other forms of credit. In this respect, it is necessary to conduct empirical discussions on the consequences of excessive bank credit.
There are numerous empirical researches and applied models proving that there is a scarce interdependence of high house prices and low interest rates. In particular, the research conducted by Faia and Macinelli (2007) has outlined that the rise of house prices is a purely national phenomenon but not the outcome of interest rate lowering. They believe that there are other essential factors that negatively affect the problem house price increase. Such factors, hence, can be presented by the quality of the good, recent financial trends, inflation, and monetary frictions. Considering the empirical model in more detail, it can be viewed that the scholars present equation modeling to provide an in-depth comparative analysis (Faia and Macinelli, 2007).
Dell’Ariccia, Igan & Laeven (2008) pointed out that over the past decade, US mortgage market has rampant expansion. According to Dell’Ariccia, Igan and Laeven (2008) there was a 50% to 75% probability of a banking crisis occur during credit booms. The mortgage crimes related to subprime mortgage market is associated the past rise of crediting. The rapid growth in subprime mortgage market is linked to the relaxation of credit standards. Subprime mortgage crisis is severe in countries experiencing a high credit boom in comparison with those having low credit rates. The increase has also been observed with regard to the total number of loans issued and loans originated in both markets.
The rampant growth is associated with credit boom which made banks to loosen their lending standards. This was most significant in the in the US mortgage market.The excessive bank’s credit not only spreading in US financial market but around other countries over the world. For example, credit expansion made US financial institutions to be aggressive in their lending. Upon US recovering from the 2000 high-tech stock bubble, a significant proportion of capital was shifted to the housing sector. For example, mortgage origination tripled during the period ranging from 2000 to 2006 to reach $600 billion (Dell’Ariccia, Igan & Laeven, 2008). The credit boom also resulted into a 90% growth in subprime mortgage market (Dell’Ariccia, Igan & Laeven, 2008).
Mankiw (2008, p. 517) asserts that when the rate of interest high, the cost of accessing loan from financial institution is high. During these periods, few investors are motivated to borrow in order to buy a house. The outcome of high interest rate is a decline in investment within the real estate sector. Availability of credit culminated into house price appreciation. This arose from a general notion that investors were gambling for the housing boom. During the housing boom period, consumer spending was high while saving was low. In addition, the investors increased their debt which became difficult to pay upon occurrence of the financial crisis.
According to Dell’Ariccia, Igan & Laeven (2008), the initial terms incorporated by banks in advancing mortgages encourage investors to take more risky mortgages. This is explained by the belief that they could easily refinance the mortgages on much more favorable terms. When the interest rate applicable to mortgages began rising while house prices decreased, it becomes difficult for individuals to refinance their mortgages (Dell’Ariccia, Igan & Laeven, 2008).
The presented evidence has a plethora of issues for further consideration. There are a great number of researches that provide various empirical models for different purposes. But the majority of models is subjected to growth and decay sample that is oriented on searching for a viable solution to a problem. Most of scholars are determined to believe that house price is the key variable depending on interest rates’ fluctuations and shifts in monetary policies. In particular, some arguments have revealed that incredibly high prices on property are primarily based on other nuances, such alternative economic policy, inflation development and prices tendencies in the world.
Alternatively, one cannot omit irrefutable ideas about existing interdependence of interest rate and house prices which is explained by the proliferation of subprime mortgage. In addition, the evolution of the US monetary policy is still strongly affected by unstable interest rate. However, this increase cannot be fully associated with house price because purchasing is not always carried out with the help of bank credits.
Ayuso J., Blanco R., & Restoy F. 2006. House prices and real interest rates in Spain. Documentos Ocasionales. 0608, pp. 1-36.
Chomsisengphet, S., & Pennington-Cross, A. 2009. The Evolution of the Subprime Mortgage Market. Federal Reserve Bank of St. Louis Review, 88(1), pp 31-56.
Dell’Ariccia, G., Igan, D., & Laeven, L. 2008. The US subprime mortgage crisis: A credit boom. VOX. Web.
Faia, E., & Monacelli, T. 2007. Optimal interest rate rules, asset prices, and credit frictions. Journal of Economic Dynamics and Control. 31, pp. 3328-54.
Granlich, E. M. 2007. Subprime mortgages: America’s latest boom and bust. Washington: The Urban Institute Press.
Haffer, R. W. 2005. The Federal Reserve System: an encyclopedia. US: Greenwood Publishing Group.
Hoffinger, B. D. 2009. US. Bank Stocks and the Subprime Crisis: An Event Study in Times of Ad-Hoc White-off Announcement to the Subprime Crises. Germany: GRIN Verlag.
Mankiw, N. G. 2008. Principles of Macroeconomics. US: Cengage Learning.
Orphanides, A. 2003. Historical monetary policy analysis and the Taylor rule. Journal of Monetary Economics. 50, pp. 983-1022.
Scanlon, K. and Whitehead, Ch. 2004. International trends in housing tenure and mortgage finance. London School of Economic. pp. 3-147.